Pre-Money Valuation of a Startup

The worth of a company before anything is invested in it is the pre-money valuation.

It is an interesting process to evaluate a startup before it goes public. This raises many discussions about the factors to consider and the methods to use. Fundamentally, valuing a pre-money startup is easier compared to a post-money startup. Businesses often have seed funding rounds in the initial stages before they decide to go public. In this article, we will tell you about the pre-money valuation of a startup, factors to consider, and the pre-Money Valuation methods.

Pre-Money Valuation

Pre-money valuation is the business’s value before receiving external funding, any other investments, or before going public. It considers the potential a company has from the start, and the progress of the company allows it to gain funding for further post-money valuations later on.

What is a pre-money valuation of a startup?

The worth of a company before anything is invested in it is the pre-money valuation. The term pre-money is used by investors and venture capitalists who are not directly involved in a business. Doing a pre-valuation helps them to determine the equity share that they will get in exchange for the money they invest in the company.

Example of pre-money valuation

ABC Inc has pre-money equity of $100 million with 2 million outstanding shares. The share price is $50.

Pre-money Equity$100 million-
Outstanding Shares2 million$50/sh
Funds raised$54 million-
Additional shares1,080,000-
Post-money valuation$154 million-
Total outstanding shares3.08 million$50/sh

ABC Inc is looking to raise $54 million of equity at a pre-money valuation. To do so, they will have to issue an additional 1,080,000 shares. The company adds the $54 million to the pre-money valuation resulting in a post-money valuation of $154 million. There are a total of 3.08 million outstanding shares with a share price of $50. The pre-money valuation formula is:

Pre-money valuation = post-money valuation - investment
= $100 million

Pre-Money Valuation vs Post-Money Valuation

The main difference between pre and post-money valuation is the time of valuation. They both measure the value of the company to determine its overall worth. Pre-money is the value of the business without the recent round of funding or external funding. The best way to describe pre-money valuation is the worth of a startup before any funding is received. This value not only tells the worth of the business but also the share price of the business.

Post-money valuation is the worth of the company after receiving investment from external investors. It includes the latest capital injection and all external financing. One thing to keep in mind while deriving the values is that pre-money valuation is the value before any funds are invested in the company. Let us take the example of Zero Inc.

The formula for pre-money valuation is:

Pre-money valuation = post-money valuation - investment

Zero has a post-money valuation of $60 million. This is after Investor A invested $6 million in the company.

Therefore the pre-money valuation would be:

  • $60 million - $ 6 million = $54 million
  • Post money valuation = $60 million

Pre-Money Valuation Formula

Pre-Money Valuation

Factors to Consider for valuation methods

While calculating the valuation of a startup, it is essential that you keep all the necessary points in mind because the pre-value of your company is the amount you will quote to potential investors. Having an accurate value will attract investors and increase funding. Here are a few points to keep in mind:

Dilution Of Shares

The main reason for the loss to initial shareholders and founders is the dilution of shares. Here is how founders shares are diluted:

  • Venture debt: Startups use debt for growth, but it has high costs. The interest rates on venture debt are much higher than banks or other financial institutions. Some venture debt has a conversion option. This means that they can convert it into common stock and become the owner of the company. This can cause founders and initial investors’ shares to dilute.
  • Anti-dilution Provisions: it is possible to be diluted by anti-dilution provisions that the early investors include in their terms. This provision is made for protecting the investor from dilution, but in a majority of cases, the investor causes issues of extra shares.
  • Options: Employee stock option plans are a good way to present incentives to employees. This not only retains talent, but also attracts more skilled employees. This is like a lottery presented to an employee for working at a startup.
  • Capital: If the company requires capital for major financial decisions, it will issue more shares. This increases the total number of shares resulting in dilution of the existing shareholders.

Revenue

If a startup is seeking venture capital investment with a revenue of $400,000, it is not much different than a pre-revenue startup. Especially if the startup is forecasting billions in future revenue, the predictions make the present revenue irrelevant. Additionally, the cash burn in the startup will also make it more challenging to accurately value the company solely based on the cash flow. If your startup has crossed the revenue threshold of seven figures, then it has made a genuine difference. The valuation can be based on the revenue, but other factors will also impact the valuation such as the return on capital and EBITDA.

Do you have reliable comparable multiples?

If you have estimated all the financial projections, you need to find companies in the same industry and region for comparison. Venture capitalists tend to compare the valuation to competitors, market placement, and the management teams. Traditionally there are four types of multiples that are comparable:

  • Acquisitions
  • Historic
  • Other VC investment
  • Public Stocks

It is a simple process to compare your company with other similar companies. If you run a technology company that has launched an app, compare it with other similar companies in the tech industry in your same region. If in any case no other data is available, use the public stocks for comparison. Historic multiples can be a trap if you miss to accurately compare. If your startup is proving itself, you need to compare it with a similar startup that reflects the same features.

It will be good to compare your startup with other VC investments, but it is not easy to gather accurate and whole data. The best option is to compare it with a recent acquisition. Ideally, you need to find a company with the same business model that is looking to do similar things that you are going to do.

Pre-Money Valuation Methods

There are various methods to calculate the pre-money valuation of startups. Here are the top three methods investors use.

Scorecard Valuation method

Also known as the Bill Payne method is the scorecard valuation method. This is one of the most preferred valuation methods by investors. In this method, the startup is compared to a similar funded startup by modifying the valuation average based on various factors such as market, stage, or region.

Firstly, the average pre-money valuation is determined for the pre-revenue startup. It is best to consider and examine various startups across the region. This provides a good baseline for the valuation. After gathering the data, the next step is to compare the startup with other startups based on factors such as:

FactorsTargetMaxWeighted Factor
Opportunity Size 145%25%36.25%
Strength of Management120%30%36%
Technology/Product95%15%14.25%
Competitive Environment90%10%9%
Sales Channels/Partnerships/ Marketing85%10%8.5%
Additional funds requirements75%5%3.5%
Others65%5%3.25%
Total--110.75%

The way you rank these is highly subjective. But keep in mind investors rank the management team higher than the product. The reason they rank it higher is that the management team is the one that runs the business. If the product is flawed the team will detect it easily and sort it out, but if the team is not capable of running the business effectively then there is no chance of profits. Then you calculate the weights to derive the valuation.

Venture capital method

In the venture capital method, you first derive the post-money valuation of the company by using the industry metric data.

It is essential here to know two equations to apply the VC method for pre-money valuation:

  • Pre-money valuation = post-money valuation — Investment
  • Post-money valuation = Terminal value ÷ Expected Return on Investment (ROI)

The anticipated value of an asset on a certain future date is the terminal value. Typically the projection period is from 4 to 7 years. The terminal value needs to be converted into the present value for it to be significant. To calculate the terminal value, one needs to study some established companies’ average sales and then multiply the amount by a figure of 2.

For example, Toby Inc is looking to raise $1 million and has projected that they will generate $40 million through the sale of the company 10 years later. The terminal value = $40 x 2 = $80 million. For investors, the statistical fail rate is above 50%, angel investors usually target an investment with a 10-30x return on investment. We will take the anticipated Return on Investment as 20x for our pre-revenue startup. We raised $1 million, post-money valuation will be $80M/20x= $4 million.

The pre-money valuation = $4 million - $1 million = $3 million

Let us take another example to understand this better, one of our current investors has an exit strategy for 7 years later in 2022, with a 30% rate of return. Our estimated revenue in 8 years is $12 million. Using these values, we calculated that the exit value is $49.2 million, pre-money valuation is $6.4 million, with the post-money valuation being $7.8 million. The investor’s share is 17.9%.

venture capital method

Berkus method

In the Berkus method, a number is assigned as a financial valuation to each of the major risk elements that all startups face. While determining the value of the startup, you give some credit to the entrepreneur for basic values and potential. Here we use both the quantitative and qualitative factors to evaluate the startup. This is based on 5 elements:

  • Product Rollout or Sales
  • Management Team’s Quality
  • Prototype
  • Sound Prototype
  • Strategic Relationships
If Exists: Add to Company Value up to:
Sound Idea (basic value)$1/2 million
Prototype (reducing technology risk)$1/2 million
Quality Management Team (reducing execution risk)$1/2 million
Strategic Relationships (reducing market risk)$1/2 million
Product Rollout or Sales (reducing production risks)$1/2 million

But this method does not stop on the qualitative drivers, as you will have to designate a monetary value to each element. The amount should be up to $500,000 for each category. This allows the pre-valuation of the startup to be around $2-$2.5 million. In the fifth year of the business, there is a $20M hurdle, this provides a chance for the invested amount to increase in value by ten times over its life.

Common Pre-money valuation Mistakes that you Should Avoid

As a startup owner, you may be new to the business world and might not have adequate knowledge to avoid mistakes. So here is a list of a few mistakes that you can avoid preventing huge downfalls.

Don’t Assume that the valuation of your startup is straightforward

In the business world, you might notice that without adequate knowledge it is not easy to do many tasks, and sometimes even with sufficient knowledge, it is still a complicated process. So never assume that valuating your startup is a straightforward process because it is not. In any scenario, where you determine a value for the business that you are satisfied with, discuss it with professionals and potential investors. Make sure that the investors are on the same page as you and that both of you are not out of your comfort zone.

Don’t assume that the valuation is permanent

While negotiating with investors keep in mind that in the end, the company will be worth how much an investor is willing to invest. As the owner, you may not agree with this but keep in mind that this is not the only variable affecting the value of the startup. There are many other factors that are mentioned in this article that affect the value of the startup and no value is accurate or permanent.

Interested to find the pre-money valuation of your Startup?

While determining the pre-money valuation, make sure that you consider all the methods and find the suitable one for your startup. It is essential that you consider all the key factors and accurately derive the value. It is best to take the assistance of a professional to help you derive the valuation amount. They will make sure everything is done accurately and effectively.

One way to accurately evaluate your startup is through the help of tools. Online tools will prevent miscalculation, omission, and other errors that can happen by mistake when calculating the traditional way. Eqvista provides you with tools through which you can evaluate your company without mistakes and helps you determine a close to an accurate value. Check out our 409a valuation services or contact us today!

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