Term Sheet Terms of the Week - March 31, 2017

Pre Money / Post Money / Upround / Downround

A lot of time in the venture capital world is talked about the valuation of a company. Investors who invest in a Unicorn are frequently willing to tell you all about it – and they should – that is a sign that their investments are doing well. There shouldn’t be much shame is sharing with the world that you have achieved some success. But what exactly does valuation mean?

A valuation determines the price that a venture capitalist is willing to spend on a deal. The price is the amount of dollars the VC is going to invest into the company. So if a company has a valuation of $10 million dollars and the VC is investing a sum of money to purchase a 5% stake in the Company, that VC will be investing $500,000 (5% x 10,000,000). So the price being paid is $500,000. This can also be broken out in a price-per-share representation, but it essentially means the same thing – a share is worth an x% of a company.

That all seems fairly straightforward, but the trick can be figuring out what the valuation actually means. There are two terms that can trip up a founder or an investor: pre-money and post-money valuation.


What These Terms Actually Mean

The pre-money valuation is what the investor is valuing the company at today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. For example, if a VC offers to invest $5 million into a company at a $10 million pre-money valuation, that offer is for 33.3% of the Company’s equity. The post-money valuation will be $15 million. The VC could have offered $5 million for $10 million post-money, and that would represent a 50% equity claim in the company.

Two other terms that are frequently associated with pre-money and post-money valuations are Upround and Downround. When a pre-money valuation for the next round of financing is higher than the post-money valuation of the last round, the investment is called an Upround. If the pre-money valuation is lower than the post-money valuation of the previous round, then the investment is called a Downround.

Uprounds are typically what an investor and a founder are working towards. These represent a growth in the investment and an increase in value in an investor’s portfolio. Uprounds and Downrounds will occur essentially until the Company launches an IPO, is sold, or merges with another company. Downrounds are generally bad signs for the founding team and investors because this means the value of the Company has decreased and an investor’s portfolio has lost value. This does not mean that an investor should immediately write-off the investment, but it is a worrisome sign.


Why This Matters

We have briefly mentioned some of the reasons why these terms matter for a founding team and for an investor, but the valuation is probably the most important thing for both parties to focus on from a technical / fundraising perspective. The valuation drives everything. For a founder, the valuation has a direct impact on how much of the company’s they need to sell to raise the appropriate amount of funds. Every new company requires capital to get take things to another level, and getting the right amount without sacrificing too much equity is critical. For an investor, even if a company is incredible and is going to be worth a ton of money someday, a bad valuation can massively hurt ROI and threaten how much can actually be earned from a liquidity event.

The reason that this is important is because the pre-money valuation has a direct effect on how much of the company the founders need to sell to get the amount of money they need for their next growth stage.  If the company’s value is set at $100 million, then the founders only need to sell a small part of the company to raise $500,000 (think less than 1%).  That’s good for the founders because they retain most of their ownership. On the flip side, if the value of the company is to be only $100k, then the founders will have to give up a large portion of the company (think 50%+).

Surprisingly, determining the value of a seed deal (usually under $1mm) or Series A stage deal (usually $1-3mm) has less to do with determining value and more to do with structuring an appropriate amount of ownership dilution for the founders.  In this sense, valuation is less of a science and more of an art (though art that requires lots of math).

Peter G Schmidt