In representing start-up companies and founders in private equity financings for 20 plus years, two of the most frequent questions that I am asked are “What are pre-money and post-money valuations?” and “How is the price per share calculated in a financing?” When raising capital in an equity financing, founders and start-up companies will always be faced with these questions, and it is critical that they understand these terms and concepts prior to engaging with potential investors or risk suffering substantial dilution.
Simply stated, a company’s pre-money valuation is the monetary value of a company calculated immediately prior to the issuance of equity securities in a financing transaction. This is often one of the most intensely negotiated – if not the most intensely negotiated – deal term in a private equity financing transaction, with founders and start-up companies generally arguing for the highest possible valuation for the company in order to retain more of the equity interest in the company following the financing transaction, and new investors arguing for a lower valuation so their investment dollars purchase a higher percentage of the company in the financing transaction. The ultimate agreed upon pre-money valuation will be determined by myriad factors, which may include, among other things, market comparables, precedent transactions, cash flow, revenues and projections, potential growth prospects and market size, the competitive environment, customer, product and service concentration, prior successes of the founders, and potentially disruptive technology.
Once the pre-money valuation is agreed upon by the company and the investors, the company’s price per share of the new equity to be issued in the financing transaction can be determined by dividing (x) the pre-money valuation by (y) the total number of issued and outstanding shares of the company. This is not always a simple exercise, as the company generally will only wish to include actually issued and outstanding shares (e.g., common stock held by the founders and early friends and family investors, and series seed and preferred series stock issued to prior investors) – employing an “issued and outstanding capitalization” figure — while new investors will argue to include not only issued and outstanding shares, but also issued and outstanding options and warrants to purchase capital stock of the company, and other securities that may be convertible into capital stock (e.g., convertible notes and SAFE instruments) – employing a “fully-diluted capitalization.” Because more shares are included in a fully-diluted capitalization, the resulting purchase price per share in the next equity financing round will be lower than if an issued and outstanding capitalization is used.
By way of example, say Newco Corp. has 10,000,000 shares of common stock issued and outstanding that are held by its founders, as well as a stock plan with 1,000,000 shares of common stock reserved for issuance as options or restricted stock, none of which are currently issued. Newco Corp. has agreed with the lead investors in a proposed Series A Preferred Stock financing that Newco Corp. has a pre-money valuation of $10,000,000. If only the 10,000,000 issued and outstanding shares of common stock are included in calculating the price per share of the Series A Preferred Stock to be issued in the financing (an “issued and outstanding capitalization”), then the Series A Preferred Stock will be issued at a price of $1.00 per share ($10,000,000 pre-money valuation / 10,000,000 shares of common stock = $1.00/share). However, if the investors prevail in including the 1,000,000 shares reserved for issuance in the stock plan in the calculation of issued and outstanding shares (a “fully-diluted capitalization”), then the Series A Preferred Stock price per share will only be $0.909 per share ($10,000,000 pre-money valuation / 11,000,000 fully-diluted shares = $0.909). Accordingly, if the investors are investing $5,000,000 in the Series A Preferred Stock financing, then at $1.00/share, the investors will be purchasing 5,000,000 shares, compared to 5,500,550 shares at $0.909/share – a 10% difference and additional dilution to the current holders of Newco Corp. capital stock. This difference is amplified if the company has significant options and warrants issued and outstanding, and/or convertible notes with conversion discounts, which can result in a significant price per share reduction and heavy dilution to the pre-financing security holders upon consummation of the financing transaction.
Following the final closing of the equity financing transaction, calculation of the post-money valuation of the company is generally determined by adding the cash raised in the financing transaction to the pre-money valuation. In our example above, if Newco Corp. had a pre-money valuation of $10,000,000, and it raised $5,000,000 in its Series A Preferred Stock financing, then the post-money valuation would be $15,000,000.
In conclusion, founders and start-up companies should fully understand pre-money valuation, post-money valuation, and price per share concepts prior to discussing the same with any potential investors, and certainly prior to signing any financing term sheets, as a misstep can result in enriching the new money investors while significantly diluting current shareholders.
