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A pre-money valuation is an estimate of a company's worth at some point prior to a round of investment from outside sources. This valuation may represent the company's financial health prior to its going public on the stock market, or prior to receiving an infusion of funds from venture capitalists who will gain partial ownership of the company. By contrast, a post-money valuation is performed after the company has received the funding and, therefore, includes that amount in the valuation. It is sometimes difficult to perform a pre-money valuation because it must often be done before the company being evaluated has fully formed.
Investors must make hard decisions about the values of companies any time they're putting their capital at risk. These decisions become even harder when the company in question is a start-up company, which may have little more than a basic idea or business plan at the time when the valuation must be done. Performing an accurate pre-money valuation can be lucrative if done well, since getting in on the ground floor of a potentially successful company can be extremely profitable.
It is important to understand how a pre-money valuation affects the investors involved once the investment is made. For example, imagine that a group of investors decide that a new start-up company is worth $100,000 US Dollars (USD); they decide to invest $50,000 USD. Adding the pre-money total of $100,000 USD to $50,000 USD investment yields a total of $150,000 USD, which would be the post-money valuation of the company.
The percentage of the company owned by the new investors in that example would be 33.3 percent, which is the total reached when dividing their investment amount of $50,000 USD by the post-money valuation total of $150,000 USD. That percentage would grow if this group had decided on a lower amount for the pre-money valuation. Entrepreneurs and company owners must agree upon this total during negotiations before the funding is made.
The major challenge for investors during the pre-money valuation stage is the dearth of information they can really establish on the new company. Since start-up companies often have no balance sheets or income reports to show to investors, it can be nearly impossible to accurately pin down their value. As a result, the negotiations between venture capitalists and company owners can be crucial to the profitability of the investment. In the case of a company going public, investors use the pre-money estimate as a way to decide the fair value of shares in the company.