Valuation

After coming to terms with exchanging ownership for cash investment, the main challenge is establishing and agreeing the valuation of your entity. Let’s say you want to borrow $100,000 and you are willing to give up 20% ownership of the company. That means you already value your business at $500,000. What is that valuation based on? Do you have customers lined up? Have you contracts in hand? What pre-orders can you guarantee?

These are questions going through the minds of the potential investors. Of course, you think your company is great, but investors need a degree of confidence that their money is going to bring a return. The less you can guarantee or predict, the more ownership they will want in order to mitigate their risk. In reality, if you have little more than a great idea, some seed capital, and a strong business plan, most investors will want more than 50% of your company from the start.

The process of valuation, however, is a negotiation between you as the person with the brilliant idea and the investors who see potential in it. Valuation gets calculated in two terms called pre-money and post-money. Pre-money refers to a company’s value before it receives outside financing, or the latest round of financing, while post-money refers to its value after it gets those funds.

Suppose that an investor is looking to fund a hi-tech startup with a check for $250,000. Based on its potential and the amount of money the entrepreneur has already put in, they agree that the company is worth $500,000. The ownership percentages will depend on whether this is a pre-money or post-money valuation. If the valuation is pre-money, the addition of $250,000 bumps up the company value to $750,000 post-money. The investor would own 250/750= one third of the equity. If the valuation takes into consideration the $250,000 investment, it is referred to as post-money, meaning the company was really only valued at $250K when it stood alone. Now valued at $500,000 the founder and investor are equal (250/500) owners.

This means that as an entrepreneur you must fight hard for the best pre-money valuation possible, which adds even more weight to the need to perform the business-plan process with real stakeholder feedback.