Valuations of early stage companies — five basic ideas

What is “valuation” all about?

Most people get the basic idea about buying stocks. Apple’s share price is around $115 today. There are a lot of Apple shares, so that if you would buy them all at $115 per share the total cost would be ~$2 trillion. That’s Apple’s market cap, its valuation.

Angel deals work the same way. We buy shares in a company. When we speak about “valuation,” we mean the share price multiplied by the number of shares, to give a valuation.

So, for example, we might invest in a company at a $2 million valuation. This means we buy shares at a price that means if we bought all the shares in a company it would cost us $2 million.

This doesn’t mean we’re investing $2 million, or that our shares are worth $2 million, or that the company is receiving $2 million.

Second, what is “pre-money valuation”?

Angels talk about “pre-money valuation” a lot. This simply means the valuation before this round of funding is being invested in the company. “Pre-money” simply means “before the investment.”

A basic goal might be to invest in companies at a $2 million pre-money valuation.

Third, the “pre-money” vs. “post-money” confusion

Angels speaking in terms of “pre-money valuations” can lead to some confusion. Entrepreneurs often think in terms of “share of the company sold” and the cost of that stake in the company. So, for example, they might say “we are selling 25% of the company for $500,000.”

Multiplying each side by four: 25% of the company => 100% of the company; $500,000=> $2 million. So my valuation is $2 million.

This math is right, but that is not the pre-money valuation. It’s the valuation of the company including the investment that has been made — because the shares are purchased and the money goes into the company. So once we’ve invested, the post-money valuation is $2 million in this scenario.

To get the pre-money valuation, we have to subtract “the money” — i.e. $500,000 from $2 million. In angel language, this is a deal with a $1.5 million (pre-money) valuation.

Got it? Good — because this mistake appears quite a lot.

Consider this TechCrunch article: on Dragons’ Den (Shark Tank with posher accents) M14 industries negotiated “a deal £80,000 for 20 percent equity, giving the young startup a £400,000 pre-money valuation.” No it didn’t.

Or a pitch we recently saw from an otherwise compelling company: “raising $350k for 10% equity, a $3.5M pre-money valuation.” No it isn’t.

Four, more complexity between “pre-money” and “post-money”

Imagine a company that has previously raised a $100,000 convertible note that would convert into equity if the company raises $500,000 of equity capital. Now it raises $500,000 on a $2 million pre-money valuation. What is the post-money valuation?

Per the last post, one would imagine $2M pre-money + $500k of money = $2.5M post money valuation, with the new investors owning 20% of the company ($500k/$2.5M). Right? Wrong.

When a deal is done, there is often more complexity than simply “new money.” In this case, the conversion of the convertible note into equity; other times, the creation of an option pool for future employees.

To account for these complications, we actually calculate as follows:

· Pre-money valuation = current number of shares multiplied by proposed share price

· Post-money valuation = post-transaction number of shares multiplied by proposed share price.

These calculations are critical, and get done with mistakes all the time!

Lastly, how do you determine the right valuation?

The short answer to this question is simply “whatever someone will pay.” It sounds trite, but it’s true.

There are weeks of online resources describing the various methods for estimating valuation; lots of places to get differing opinions on what the valuation “should be”; lots of companies charging to help you “determine” your valuation; and places you can go to learn more.

All of these are nice, but fundamentally investors don’t care what other people with no skin in the game think. For our money, all that matters to us is what we think this company is worth. That’s the right valuation.