pre-money valuation

A New Hope

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Preamble: Like all great Hollywood franchises, The Cap Table will be a trilogy.  I can tell already, you are on the edge of your seat in suspense…  There are a ton of valuable insights and important signaling events that a cap table represents, so I want to make sure I touch on everything appropriately.

The last couple of blogs have covered valuations and how we find them.  Every time a company raising new capital it is setting a new valuation, selling a portion of the equity, and is re-establishing an exit target.  There are reasons to raise new money, and there are costs and risks associated with each incremental raise that I will try to outline here.  I’ll walk through the funding process from the perspective of new company – HotStartup.  Without further ado, I present – A New Hope.

Friends and Family

When HotStartup is first starting out, it is just an idea in the back of our heads that will solve the Middle East conflict, eliminate starvation, and fix the healthcare system all in one shot.  It’s a rocket ship and we know it will work.  To get the first few dollars to build a prototype, get some first beta versions coded up and tested out we will use our own money, ask friends, family and anyone we know for some help.  This is called a Friends and Family round, and really represents people putting money into the business based their relationship with you, and less about the actual business.  Often this is in the form of a loan, credit cards, mortgage on a house, etc.  Not really selling any equity, or if you are, it is part of the founder’s share of the business.

Angels / Seed Stage

But, since HotStartup is the best thing since, well ever, we see some great traction from our test customers and are starting to really refine the product.  To get the whole thing working, we will try and raise $1,500,000 of capital in order to hire a few people and really build an enterprise ready product.  At this stage, we are trying to raise an Seed Round, where either an institutional Angel group or seed stage investor will invest (such as Hub Angels or NextView Ventures) or even some privately wealthy individuals throughout our geography (such as high profile MA angles like Jonathan Kraft).

At this point, we need to start thinking about valuation and how much equity we are willing to part with.  Since we don’t have sales or revenue to benchmark against, it is hard to know how much the business is worth.  Often people will look at industry averages for a seed stage business, which the median pre-money valuation is currently is ~$5.2mm (mm = million, each “m” represents 1,000x, so $4m =$ 4,000, $4mm = $4,000,000).  Since we have already covered pre-money valuations, we understand that our pre-money valuation of $5.2mm and a total equity raise of $1.5mm yields a post-money valuation of $6.7mm, and we are selling 22% ($1.5mm/$6.7mm = 22%).

Series A

We’ve got it!  A full product, we’ve tested it out and people want to buy our HotStartup software.  AWESOME!!  This is fun.  But, do we want to sell this as a perpetual license (think Microsoft Office, you sell a CD with everything on there, and people can use it for the rest of time), maybe a subscription license (where people pay us monthly/annually, like Netflix), or even a fully hosted SaaS solution (the newest trend is a SaaS offering, meaning we not only sell the product as a subscription, but also host it on our own servers).  This process of figuring out the business model is when we go and raise a Series A round, with some really good venture capitalists that will help us think through things and guide us.

Again, it is a little early to really set the valuation based on our sales, but we aren’t just an idea anymore.  Maybe we set things based some other user metrics or try to get a valuation of the business from a potential acquirer.  For HotStartup, we will assume an industry average increase in the valuation of the business – a new pre-money valuation of $9.2mm and we can raise an additional $4mm cash (again, pre-money of $9.2mm plus the $4mm of equity raised yields a $13.2mm post-money, selling a 30% stake in the business)!  This represents more dilution for us as founders, but also dilution from Angel investors.

Making it rain

Since we have some ideas of when, why and from whom we can raise money, let’s focus on some of the nuances of what this all means and how it impacts us.  I’ve attached a breakdown of how the cap table would look if we raised new money from one investor at a time, with no participation from past investors.  This is a simplification of the fundraising process, but helps to show how our founding stake in the business quickly goes from 100% to 54% after the Series A.  After the Series A round, the implied value of our shares has been rising quite rapidly and is worth $7mm!  So dilution means we get a smaller percentage of the company, but it is at a higher valuation.

In Part 2 we will cover financing through the end of venture (usually considered Series D), while finishing up in Part 3 with an analysis of some of terms in a venture contract (liquidation preferences, participation rights, drag along rights, anti-dilution clauses, etc.).

Seed and Series A Cap Table

Valuing an investment

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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.