What Is Pre-Money Valuation?
Pre-money valuation refers to the estimated value of a company before it receives new capital from investors by going public or from external funding or financing.
The term is often used by venture capitalists and other investors who aren’t directly involved in a company. A pre-money valuation in combination with their potential investment amount allows them to determine what their share in the company would be.
Pre-money valuation is often referred to as “pre-money.”
Key Takeaways
- Pre-money valuation is the estimated value of a company before it it goes public or receives external funding or financing.
- It can help potential investors understand how much the company may be worth before they invest their money.
- They can also use it to determine their ownership stake.
- Pre-money valuations are different from post-money valuations, which indicate a company’s worth after it receives funding or financing.
- Pre-money and post-money valuations can be a gauge of potential growth.
Understanding Pre-Money Valuation
Pre-money is the value of a company before it receives investments or rounds of financing. It gives investors a picture of what the company’s current value may be.
Pre-money isn’t necessarily a static figure. It changes over time as new funding is sought. That’s because the valuation is determined before each new round of financing (whether that’s private or public investment).
For example, pre-money would be determined before an initial public offering (IPO). It would also be figured before seed, angel, or venture capital funding is put into a company, either initially or over time if the company seeks additional funds.
Determining Pre-Money Valuation
Before receiving any funds, a company can estimate its pre-money valuation based on financial statement data, scalability, the value of comparable businesses, the state of the industry, conditions in the relevant market, the potential seen in the senior management team, and more. Or, the pre-money valuation may be a figure proposed by a potential investor.
The leadership of a company might reject pre-money valuations proposed by others until they reach an amount that’s in line with the calculations and aspirations of the company.
Calculation
Once a company receives funding, its value includes that money. This is known as a post-money valuation. Consequently, going forward a pre-money valuation is determined by subtracting potential new funding opportunities from the post-money valuation:
Pre-Money Valuation = Post-Money Valuation – Investment Amount
So a company whose post-money valuation is $20 million after receiving a $3 million investment has a pre-money valuation of $17 million ($20 million – $3 million).
How a Pre-Money Valuation Is Used
A company can use a pre-money valuation as a clear starting point for finding and negotiating with initial investors, or additional ones at a later time. The higher the pre-money valuation, the more interested investors may be.
In addition, would-be investors use the pre-money valuation to determine their potential ownership stakes or the amount of money they may choose to invest in exchange for a certain ownership percentage.
The pre-money valuation is also used to determine the per-share value of shares to be sold to the public (pre-money ÷ total number of shares).
Before a company ever receives outside investor funds, a pre-money valuation is an estimated, subjective value. It can be based on financial statement data, the value of comparable businesses, and the potential seen in the senior management team.
Types of Pre-Money Valuations
Two common pre-money valuation methods used by companies and investors to determine whether a potential investment is worthwhile are:
1. Discounted Cash Flow (DCF): DCF helps companies and investors understand the value of a potential investment by analyzing projected future cash flows.
Investors can use DCF to determine the amount of money they may receive by investing in a company. And if the DCF is greater than a potential investment, then the investment may be worthwhile.
2. Comparable Company Analysis (CCA): CCA compares competing companies in the same industry with similar objectives and of similar size. To make this comparison, it uses such measurements as price to earnings (P/E), price to book (P/B), price to sales (P/S) and enterprise value to sales (EV/S).
Should the company being evaluated have ratios that are higher than its competitors, it can be seen as overvalued. This can affect how investors negotiate with a company, what they seek in return for their funding, or whether they invest at all.
Special Considerations
Early Valuations
Early stage valuations can coincide with the company being pre-revenue, meaning it has yet to generate any sales. This may be because it doesn’t have a product on the market yet.
Investors can still determine the company’s value, basing it on a variety of other factors. One such measure may be comparable businesses, as noted above. An assessment of the revenue and market value of more established, mature companies with a similar focus and operational approach can serve as a gauge of the potential for pre-money companies.
Even if pre-money companies claim that they are creating an entirely new industry with new business models, their prospects will likely be cast in the vein of an earlier business. For example, if a new company plans to produce a new type of automated vacuum cleaner, its pre-money valuation might be established in part by assessing the performance of other makers of robot vacuums.
Other factors that may contribute to a pre-money valuation include the experience and track record of its founders and leadership executives, the feasibility of delivering on promised services, and the challenges that may be posed by competitors.
Investors should make sure they don’t spend money they don’t actually have when they talk about pre-money valuations.
Example Using Pre-Money Valuation
Jim’s Donut Shop is a thriving business with several locations in the region. The owners want to capitalize on their success by branching out with an additional shop and new product offerings. But it needs to attract new investors to do so.
A pre-money valuation in conjunction with a potential investment amount will show the equity ownership an investor can expect.
The company determines its pre-money valuation based on its financial statement information, ongoing demand for its products, economic conditions and outlook, competition, and high quality leadership.
The owners can benefit from an attractive (high) pre-money valuation because it would mean giving up a smaller percentage of ownership, should the investment take place.
Jim’s Donut Shop has a pre-money valuation of $5 million. There’s a potential $1 million investment on the table:
- Investment: $1,000,000
- Pre-money valuation: $5,000,000
- Post-money valuation: $6,000,000 ($5,000,000 + $1,000,000)
- Ownership percentage: ($1,000,000 ÷ $6,000,000) = .17 x 100 = 17%
So, in exchange for the $1 million investment, the owners of Jim’s Donut Shop would forego 17% of their ownership stake.
Pre-Money vs. Post-Money Valuation
Post-money valuation is different from pre-money because it indicates how much a company is worth after it receives an investment. The post-money valuation is the total of the pre-money plus the additional equity injected into the company.
This includes any amount of capital, whether it’s raised through a public offering or through private, external sources.
So, if a company’s pre-money valuation is $25 million and it receives $5 million from an investor, the post-money valuation is $30 million.
Post-money valuation is an important figure because it’s a more accurate rendering of value and investors can use it to negotiate their share of equity if they invest in a company. A potential equity share can also be calculated using the pre-money valuation, as noted in the example above.
Why Is Pre-Money Valuation Important?
It’s important because it can serve as a starting point for negotiations between a company and potential investors. It can also be used to help determine the share of ownership that an investor could receive.
Are Pre-Money Valuations Made Only Once?
No, they can be calculated repeatedly, depending on whether or not a company needs outside funding. An initial pre-money valuation normally occurs in preparation for a first round of external funding. Thereafter, should a company need more funds via, for example, an IPO or individual investors, additional pre-money valuations would take place.
Which Is Better, Pre-Money or Post-Money Valuations?
While pre-money is an estimated value, post-money is a more accurate view of current value and potential growth.
The Bottom Line
Pre-money valuation is a term that refers to the value of a company before accounting for outside investments. It’s a figure that can be used to attract investors, determine an ownership stake for an investor, and determine the per-share value of shares to be offered for sale. Investment amounts plus a pre-money valuation add up to a post-money valuation for a company.
