Before entering into the boxing ring with investors, it is important to become well versed in valuation terminology and practice the mental gymnastics of valuation calculations. Keep in mind that on one side of the ring, you will likely be highlighting the promising potential and future of your project. On the other side, the investor will likely be focusing on what you have been able to execute thus far.
(Author: Nicolas Valaize, nyuko / Image Credit: Fabian Blank)
Take the example of NextUnicorn. The startup has been in existence for six months, it has a radiant team and the ambition of closing a first financing round of€300,000. Investors show interest in exchange for a 25% stake in the company. NextUnicorn is then valued at €900,000. Are you wondering, if a quarter of the company is sold for €300,000, doesn’t it mean its value is actually 1.2 million?
Not exactly. If you sell 25% of your company for €300,000, it is only valued at €1.2 million after the investment takes place (i.e. post-transaction). This€1.2 million is called your “post-money” valuation. But what interests us is the fair valuation before getting this investment, namely the valuation of what you have built so far. To calculate the “pre-money” valuation, you simply have to subtract the amount of funds raised from the post-money valuation.
Pre-money and post-money valuations must be mastered by every entrepreneur who wants to calmly and confidently approach investors.
Post-money Valuation = Funds Raised / Agreed Percentage and Pre-money Valuation = Post-money Valuation – Funds Raised
When NextUnicorn is considering selling 25% of its capital in exchange for € 300,000, it calculates:
Post-money Valuation = Funds Raised / Agreed Percentage = €300,000 / 25%.
This equals an enhancement after transaction, or post-money valuation of €1.2 million. It can therefore deduce its pre-money valuation by applying the second equation:
Pre-money Valuation = Post-money Valuation – Funds Raised = €1.2m – €300,000.
So, when the founders of NextUnicorn are demanding investors pay €300,000 in exchange for 25% of its capital, they are implying that their company is worth €900,000 today.
Here are some more examples to help you become a valuation master so that you feel confident when you meet with investors.
If I want to raise €650k, what percentage of my company would investors get if I negotiate a pre-money valuation of €2.5m?
Answer: €650k / (€2.5m + € 650k) = 20.6%.
What is the minimum pre-money valuation I have to negotiate, if I do not wish to dilute my company by more than 25% on a round of € 400k?
Answer: €400k / 25% – €400k = €1.2m.
What is the pre-money valuation the investor will offer when claiming 18% in exchange for € 500k?
Answer: €500k / 18% – €500k = €2.3m.
Commonly, business angels will focus on your pre-money valuation, challenging you on what you have done so far. On the other hand, an investment fund will usually seek a post-money percentage as high as possible. This will ensure, after successive dilutions of fundraising, a sufficiently attractive percentage for the fund at the time of resale or IPO of your startup. How to calculate or demonstrate a level of pre-money valuation.
Let’s start by forgetting everything you learned in finance courses pertaining to valuing a business. In reality, there’s no magic formula.
Evaluating your startup will be the result of your negotiation with investors and the following factors:
the total amount to cover up to 12 to 18 months of cash burn;
the percentage of capital that investors will receive;
the competitiveness of the deal: are investors racing to your door?
The secret is to anticipate investors’ negotiation tactics and be the first party to announce the level of pre-money valuation desired. In most cases, the investors will be able to negotiate a lower valuation so it is important to aim high from the beginning in order to end up with a valuation with which you’ll be happy. Method: To steer you in the right direction in this delicate task, Dave Berkus, a renowned business angel from California, offers the following pre-money valuation method for a startup in its early stages:
(Put in your own values) Features To add to the pre-money valorization
Good idea : From €0 to €500k
Prototype functionality: From €0 to €500k
Quality of founding team: From €0 to €500k
Strategic relationships: From €0 to €500k
Driver/Traction level: From €0 to €500k
I advise applying this method mainly to startups that aren’t yet generating income and that have the ambition to exceed the €20 million turnover within 5 years.
This article was first published in SILICON