Startup pre-money valuation
From the moment that your wonderful business machine will start receiving funding, it will have a different valuation before and after the investment itself.
Pre-money valuation is the preliminary valuation that is made prior to an investment by an external investor, such as venture capital or business angel, and it is necessary to determine the amount of return on equity of their investment. This investment is calculated on a fully diluted basis; In fact, you will most likely receive rounds of funding (round A, B, C, etc.) rather than a lump sum in order to decrease the risk for investors and to motivate entrepreneurs Pre- and post-money valuation concepts apply to each round and there are various calculation methods.
One of the most used:
Shareholders of XXX srl own 100 shares, which is 100% of equity. If an investor makes a $10 million investment (Round A) into XXX srl in return for 20 newly issued shares, the implied post-money valuation is:
$10 million * (120/20) = $60 million
This implies a pre-money valuation equal to the post-money valuation minus the amount of the investment. In this case:
$60 million – $10 million = $50 million
The initial shareholders dilute their ownership to 100/120 = 83.33%.
Let’s assume that the same XXX srl gets the second round of financing, round B. A new investor agrees to make a $20 million investment for 30 newly issued shares. If you follow the example above, it has 120 shares outstanding. The post-money valuation is:
$20 million * (150/30) = $100 million
Pre-money valuation is:
$100 million – $20 million = $80 million
The initial shareholders further dilute their ownership to 100/150 = 66.67%.
Upround and downround are two terms associated with pre- and post-money valuations. If the pre-money valuation of the upcoming round is higher than the post-money valuation of the last round, the investment is called an upround. The downround is the opposite. In the above example, round B was an upround investment, because pre-money B ($80 million) was higher than post-money A ($60 million). A successful growing company usually receives a series of uprounds until an initial public offering is made (IPO) or it is sold or merged. Downrounds are painful events for initial shareholders and founders, as they cause substantial ownership dilution and may damage the company’s reputation. Downrounds were common during the dot-com crash of 2000–2001.
The second method:
First time experience team with only one founder (1)
Well-assorted team (tech+webdesign+product/marketing) without previous business experience (2)
Well-assorted team with good previous experience (4)
Team of digital veterans with successful companies and exits behind them (7)
Top team, previous IPO rather than trade increases from 50 million Euro (10)
Just an idea (1)
A well-argued idea and field interviews that validate its principles (2)
Prototype developed well in beta and visible online (3)
Beta online for a few months and first iteration cycles already completed (4)
Stable and well-developed product (5)
Private Alpha with a substantial waiting list and first positive comments to the service (2)
Public beta with steady and constant growth (3)
Public beta with vertical growth (5)
Exponential growth (8)
no revenue (0)
first revenues without specific growth (1)
early sales but with perceivable growth month/month (3)
stable revenues with strong growth (4)
revenues with exponential growth (6)
Potential market size
Italian niche market only. Total addressable market <50 million Euro (0) International niche market. TAM > 250 million Euro (1)
Italian market only. TAM > 250 million Euro (2)
International market. TAM = 1 billion euro (4)
International market. TAM> 1 billion euro (6)
Pre-money valuation table:
between 1 and 4 points – 0 value
between 4 and 6 points – between 100k and 300k euro
between 7 and 11 points – between 400k and 800k euro
between 12 and 15 points – between 1 and 3 million euro
between 16 and 18 points – between 3 and 5 million euro
19-20 points – between 6 and 10 million euro
A third method – Venture capital method:
The startup valuation at the first round.
In case of a recent startup, the valuation depends largely on the belief that the growth of the startup will bring future prosperity for those who invested in it. Generally, the valuation is determined by a reverse process rather than that which you would imagine.
Let’s suppose it’s your startup, and that your startup needs 100,000 euro to grow its project over the next 18 months. This figure is not negotiable because it is the minimum amount needed to secure growth. The amount of the investment is therefore determined ex ante.
What is not determined, however, is the share that the startup will give to the investor in return for the 100,000 euro investment. The share should not exceed 50% because otherwise you would risk being less motivated to work. It also cannot be too high, otherwise there would be no room for new investors in any subsequent round. The amount generally given for such investments is therefore distinguishable by a difference ranging from 5% to 20%.
If the investment is 100,000 euro and your share is between 5% and 20%, then the pre-money will be between 500,000 thousand euro (20% of the company) and 2 million euro (5%).
The choice of the investor’s share is determined by:
- how much the other investors have valuated in the past or are considering similar startups
- the growth potential of the startup
- relative metrics: turnover, users, traction, reputation.
Startups who close a seed round with a venture capital are often valuated with a slightly different approach from the previous one, even though it has not been developed in detail yet. This is the so-called venture capital method. This method was elaborated in 1987. The first to use it was Bill Sahlman, a Harvard Business School professor.
The valuation calculation is based on the expected return on investment (ROI) and the Terminal Value, which measures the startup sale price expected for approximately 5-8 years.
When closing the first round, the formula to be applied is the following (Source: hbs.edu):
ROI = Terminal Value/Post-Money Valuation
Post-money valuation = Terminal Value/Anticipated ROI
Let’s look at the previous terms in detail and let’s see an example.
You can use various methods to determine the Terminal Value. Generally, when it comes to a startup, the value based on future cash flows is not calculated as typically done for traditional companies because these are too uncertain. Most often, the “Multiple Method” is used; a comparative method based on indicators that express the relationship between the value of the company depending on the value of similar companies and some key variables such as revenue and profits. Let’s suppose that the Terminal Value is 50 million euro.
The anticipated ROI, on the other hand, depends on the investment risk. In general, it is plausible to expect that 9 investments on a portfolio of 10 will either fail or not be able to offer a ROI greater than 1x (one for the invested value – that is, the full recovery of the invested amount). For this reason, all investments, before being made, must be likely to offer a return between ten and twenty times the value invested. Let’s suppose then that the Anticipated ROI is 20x.
Then the formula becomes: Post-money = 50M € / 20 = 2.5M €