We’re getting it.  Big institutional investors give money to venture funds, which in turn invest that money into companies.  Those companies grow like crazy, get sold for lots of money and everyone is happy.  If only things ever were that simple.

In order to understand what type of investment works best for a start-up, it important to understand how these companies are valued, how investments ultimately are structured, and how each party (institutional investors, venture funds, and the company) share in the ultimate profits.  Each investment type is a little different, and there are lots of ways to structure a deal.  We’re getting a little ahead of our ski tips here, so let’s understand how to calculate the value of company when they raise money.

Most investments we hear about are equity investments.  It’s what venture capitalists (VCs) do, and it is how most companies are able to raise money.  In the most basic sense, venture capitalists are doing the same thing you do on E-Trade when you buy stock in Google.  Your stock is actually ownership in Google, and ultimately entitles you to the profits of the business.  Venture capitalists are just buying much larger amounts of ownership in much younger, smaller companies.

Using an example is probably the easiest way to think about this.  I love Dropbox, and many of you likely do too.  Well, they just raised $250 million at a $10 billion valuation.  So, how much equity did BlackRock (in this case, the VC that made the investment) get in the business?  The simple way to calculate the amount of equity is divide take the amount of money invested ($250 million) by the valuation of the business ($10 billion).  So in this case, 2.5%.

Wait, what? Why does this matter?

Think of it this way, if we are giving a company $250 million, we just made that company worth $250 million more.  So when we invest our money in a business, we are actually making it more valuable!  So we calculate what is known as the pre-money valuation, and use that to value our investment.  In a normal, simple deal, the pre-money valuation is simply the valuation we hear about (known as the post-money valuation), and subtract the amount of capital raised.

In the Dropbox example, this means we take the $10 billion post money valuation, subtract the new capital raised of $250 million, and get a pre-money valuation of $9.75 billion.  Although that is not a big change in this example, it is a big difference in the smaller deals.  A $20 million investment in a $100 million business would be 20% (if that $100 million investment represents the post-money valuation). From a Company’s perspective, they went out to raise money at an $80 million pre-money valuation.

This is boring.  You’re bored, I can tell.  Honestly, I’m bored too.  But, it matters.  It matters a lot actually.  Remember last time we talked about A16Z investing $22 million into Silver Tail and selling it for $2.1 billion dollars?  Well, without knowing the valuation that A16Z invested into Silver Tail we don’t how much money A16Z made.  If A16Z invested their $22 million into the Company at a $3 billion valuation, they actually would have LOST money, despite it selling for $2.1 billion!

We hear of the big numbers a lot.  But they really are only part of the story, and we rarely hear the whole story.  Taking it all the back to our E*trade account: you bought stock in Google Thursday (1/16) and sold it on Friday (1/17) for $1,150 – that’s a lot of money!  But it doesn’t mean anything… you would have paid $1,156 for it on Thursday.  So selling it on Friday, you actually would have lost $6.  That’s why the valuation is so important.

That is why we care and why it is important to understand the whole picture.  Pre-money and post-money valuations are not interchangeable, and make a huge impact on the actual returns to the venture fund and to the company.  They change how much equity a company has to give away to get new money, and at what price an investor is willing to invest in a company.