Why is the pre-money valuation different than the value of almost everything else?
We think this is most easily explained with pictures...so here they are with very short descriptions.
In a normal transaction (that is, a non-early stage equity investment) -- if you had something worth $100 and you sold half of it, your ownership stake would be reduced to $50. And the person who paid you the $50 would own the other half.
If, on the other hand you had an early stage company worth $100 before raising any money (the Pre-Money Valuation) and an investor wanted to buy 50% of your company, it would cost them $100 as shown below.
Why is this? The best way to think about it is that investors in early stage companies are hoping that you'll be able to take their money and create much more value, but that the money they are providing is a required part of the equation to be successful. So in reality, investors are not buying a part of something you already have, they are expecting that you will substantially increase the value of your company with the funding they provide, and because of that, the investment they provide should increase the value of your company by the amount of money that they provide.
The resulting equation for understanding these types of financings is...
PRE-MONEY VALUATION + MONEY INVESTED = POST-MONEY VALUATION
Why is the pre-money valuation important? Is it really as important as it's cracked up to be?
Well, if you play around with this tool then you'll get a very good feel for how important this number is in the grand scheme of things -- at least from the financial perspective. The basic story is that early stage companies get valued (by the outside world) based primarily on comparables. This is especially true for pre-revenue companies that are building their venture around a promise of things to come. So, while it's prudent to know what the comparables are in your space, it basically means that unless you've really got a super-star track record, you are going to be valued in a range that is pretty much nailed down to a range, though it may be a broad range, before you start. That changes in later rounds.
A few thoughts on working your way toward a fair, and hopefully less random, valuation (for very early stage ventures).
(NOTE: Almost all of this is geared at discussing the first money into a venture. This does not attempt to address later rounds of funding for more mature ventures because at that point everything is very venture specific and tough to discuss in generalities.)
- First, if at all possible use convertible debt in the earliest stages and provide your investors with a conversion premium to reward them for the risk they are taking. This can really enable a young venture to position itself better for a more equitable valuation at a later time. Select "Convertible Debt" in the tool for more information on this. You'll find it under the icon of the Money/Investment Raised category.
- If that's not doable, or if you've outgrown that stage, go learn about some comparable deals that have happened and find out what their valuations were. Then, try to be really intellectually honest around how much you've really accomplished and what is left to do. Another way to think about it is this: If you think there is a chance that you'll raise a second round, you don't necessarily want to overstate your value early on unless you don't mind screwing your earliest investors. An exercise that may be worth pondering -- what is the valuation of your company that you would feel good about letting your Mom, Dad, or a mentor invest? That, of course, assumes that you'd like to see your earliest investors do well.
- Don't take the first money that someone tries to throw at you. Founders frequently get really excited when someone shows enough interest to invest in their venture -- Don't! That's great validation that you're telling a compelling story, but regardless of what any funder tells you, you owe it to yourself to get a few opinions on valuation.
- In many cases it makes sense to take a lower valuation if it means you can get the right partner on board -- this is discussed more in the "Investment/Money Raised" section but it's worth mentioning multiple times. If you're looking for an investor who brings more than money to the table -- partnership, experience building businesses like yours, the right network -- then it can be worth sticking with a lower valuation...but hopefully not too much lower.
The most common problems we've seen in this space are below (and keep in mind, we love founders!):
- Founders always seem to think their idea or company is worth more than it is. For some reason, and maybe it's just our experience, everyone seems to think their idea is worth exactly $10 million dollars out of the gate before anything really exists. This is not where very early stage deals get done (with the obvious caveat that some deals do get done there). Of course it depends on where your company is in it's life, but seed stage deals, where bets are being placed on a future state that is nowhere near existing, typically get done in the sub-$5 million range. More frequently (and usually appropriately) around the $3 million range. Many times it's in the sub $1 million dollar range for very good reason.
- Investors try to take advantage of under-informed founders in ways that are really non-sensical. This is certainly a little touchy, but in all reality the pre-money valuation is but one term and (at least early stage) investors frequently get all kinds of other protections if things don't go well, so hammering a founding team too hard on the last $500K of a pre-money valuation just results in bad blood.
If you haven't already read the following resources and you're interested in this topic, GO THERE IMMEDIATELY and consume. They are really fantastic posts.