At Founders Workbench, we stress the importance of founders understanding the economic terms of a financing round. Valuation is the most fundamental term founders encounter during a financing round and is crucial to understand when evaluating a term sheet.
Valuation is generally thought of two ways – pre-money and post-money. The “pre-money valuation” is the investor’s valuation of the company today, before the investment. The “post-money” valuation represents the pre-money valuation PLUS the amount of money raised in the round. Valuation is so critical because the amount raised divided by the post-money valuation determines the percentage of the Company that the investors are entitled to in connection with the round.
For example, if we had a $5 million raise, on a $5 million pre-money valuation, resulting in a $10 million post-money, the investors would be entitled to ½ of the equity of the Company. And presumably, the founders would assume that they will retain the other 50% of the Company. But this isn’t true if there in an incentive pool being put in place. For example, if a 15% incentive pool was being put in place, this would impact the founders (and possibly the investors) in one of two ways.
If the pool is being implemented on a post-money basis, then the pool would dilute both the founders and the investors, such that founders would own 42.5% of the Company, the investors would own 42.5% of the Company (together totaling 85% of the Company), and the incentive pool would represent the remaining 15%. More typically in early stage rounds of financing, the pool is accounted for in the pre-money, which means that the investors are not diluted by the pool. So, in this example, the investors would get 50% of the Company, the incentive pool would represent 15% of the Company and the founders would be wind up with the remaining 35% of the Company.
A common question from founders, even before the term sheet surfaces from the investors, centers around valuation: how do I value my company? Valuation at the early stages is more art than science, as there is generally no revenue, let alone profits, for meaningful comps. So valuation is much more a function of negotiation, and competition is a founder’s ally. If many investors want in, founders can leverage that interest for a higher pre-money valuation. There are a host of intangible factors that impact how investors are willing to value a business, but what it really comes down to is how much of the Company are they going to get for their investment.
If you’d like a deeper understanding of Valuation and the general anatomy of a Series A Term Sheet, Founders Workbench has additional resources to help you. We recommend you check out the Google TCN On Air Google Hangout with Bob Bishop , which does a deeper dive into these concepts. You can also access helpful documents for financing a startup company by visiting the Founders Workbench Documents Driver.