Posted by Shivali Anand
August 11, 2021 | 4-minute read (705 words)
There are several terms you should know when you’re seeking funding for your business, but "pre-money" and "post-money” are by far the most important. You will likely hear these terms many times during a venture capital investment round, whether it’s regarding a capitalization table or term sheet. Understanding pre- and post-money is important because they relate to the valuation and funding of your firm.
A company's pre-money valuation refers to its value before receiving any external investment. This figure gives investors an estimate of the company's worth and the value of each issued share.
A company’s post-money valuation refers to its value after it has received funds and investments. A company's equity value rises as money is added to its balance sheet, so the post-money price is always more significant than the pre-money price.
Pre-money versus post-money in action
Distinguishing between pre-money and post-money valuation is important as it will determine the equity stake investors are entitled to after fundraising rounds.
Let's consider an example: An investor is interested in funding your firm, and you jointly determine that your company is worth $1 million. The investor decides to put $300,000 into it.
The claim percentages for you and the investor will differ depending on whether the $1 million valuation is pre-money or post-money. If the valuation is pre-money, your firm will be valued at $1 million before the investment is made. After the investment, it will be worth $1.3 million. If the $1 million value incorporates the $300,000 investment, it is referred to as the post-money valuation.
Related financing terms to know
When working with corporate finances, it will be beneficial to get familiar with the following funding terms.
- Common Stock: Also known as voting shares or ordinary shares, is a kind of equity ownership that represents owning a piece of a firm. It's a form of stock that provides you a portion of a company's ownership and voting rights at shareholder meetings. The quantity of ownership is the difference between how much common stock a person owns and how much was issued.
- Preferred Stock: A type of equity with debt characteristics. Preferred shareholders, like regular stockholders, receive a share of an organization's ownership. They also have specific rights, such as guaranteed dividends that must be paid before common shareholders' payouts and priority in the event of liquidation. Preferred stock is traded at a different price than ordinary stock and is listed separately from common stock.
- Liquidation Preference: A type of preferred stock issued to investors. Preferred stock is typically provided to venture investors as equity. When a firm is bought out or goes bankrupt, liquidation preference gives investors priority for compensation. After the shareholders have received their portion, preferred stockholders are the next to benefit from the company's liquidation. Note that there are three types of liquidation preference:
Straight or nonparticipating: Generally the best option for a business. Preferred stockholders can either recover their initial investments plus accumulated dividends if the company is liquidated, or they can convert their shares into ordinary stock and be regarded as common stockholders if the company is liquidated. Remaining funds are distributed to common shareholders.
Participating in the process: Usually advantageous to investors. The investor receives their investment plus any accrued dividends. The investor is also treated like a common stockholder and is generally paid twice.
Capped or partially participating: Confers all the benefits of a participating preference, except the investor's money is capped. When an investor has attained the capped amount, they are typically unable to accept any more.
- Convertible note: A form of debt that, rather than being used as a typical loan repaid with interest, changes into equity in exchange for an investment.
- Round size: The amount of money a firm gets from a round of financing. When entering into an investment round, it's critical to consider more than just the round size. It’s also crucial to think about the terms of the loan, such as the overall amount of equity being given up.
- Option pool: The number of shares set aside for future workers and investors. It's the proportion of a firm that the owner is willing to give away in the future.