Pre-Money and Post-Money
Imagine your company right now is worth £400k. Someone invests £100k. What do they get for that? Well after the investment your company will have an extra £100k in cash, along with whatever it had before that made it worth £400k. So the original £400k + the new £100k in cash values it at £500k.
The Pre-Money valuation of the company is £400k. The Post-Money valuation of the company is £500k.
If an investor gives £100k, he or she is getting shares in the company upon the company’s receipt of the money; that means the investor has a share of the post-money company. Therefore, the post-money valuation is used to determine the number of shares given to the investor.
In this case, a contribution of £100k to something worth £500k means an equity share of 20%.
Strictly speaking, a company wouldn’t take £100k, nor would an investor give it, if either of them thought that the company would not increase in value, with that money, beyond the value of the money. The idea is that by combining the assets that the company already has before the money, with whatever it is that the company can now buy with the money, it will be worth more than the sum of the post-money valuation.
Does that mean the company should be valued at more than its post-money valuation, to reflect its new capabilities with the money? No, but nice try. The growth in value of the company that will be caused by combining the company with the new money is exactly what the investor is seeking- otherwise the money could be left in a bank without any risk.
This is important when it comes to how you value your company when seeking investment…
Risk and Valuation
From a financial perspective, success comes when the company is bought (either in a sale or the shares are bought by the public on a stock exchange) or becomes so profitable that it can continue paying dividends to its investors. If you think of that moment as a point in time, then the earlier an investment takes place, the farther from that point (success) it is.
Time carries with it the risk of failure, and so the more time between an investment and success, the more risk there is. That means earlier investments are more risky to the investor because the company is more likely to fail. This explains why earlier investors take more equity in relation to their investment- they are taking more risk, and so must be compensated for it.
The other way to think about this is that the later the stage at which an investment is made, the less risk there is, and so the higher the valuation of the company. As a company moves closer and closer to success- a sale or ongoing dividends- its valuation will move closer and closer to the valuation it will have at the time of that success.
For example, let’s say that if a company were to succeed in its plan, it would earn £1m per year in profit after tax, and be bought for £20m for doing so. Upon first being founded, the probability of it succeeding might be only 2%. That means its value is 2% of £20m, or £400k. So if you raised £100k at this stage, at a valuation of £500k post-money, you would have to give up 20% of your equity.
Fast forwards a few years. The company is now just a few months away from reaching its £1m per year profit rate and being sold. The risk of it not getting there is much lower, so perhaps we give it a probability of success of 80%. That means the value is 80% of £20m, or £16m. A new investment of £100k would lead to a post-money valuation of £16.1m, so the equity to be given up would be 0.6%.
This explains why a company isn’t valued at more than its post-money valuation; it is still just as far from success as it was before the investment.
In reality, people don’t value startups as a probability function of a future valuation- neither could be meaningfully known. Larger companies with steady cash flows are valued like this, through cashflow discounting, but for a startup it is much more of a negotiated settlement.
Methods of Valuing Startups
Cashflow discounting, the method used to value larger companies, is difficult enough. Even if you knew with 100% certainty that a company would bring in £1m per year for the rest of its existence, and you knew the interest rates and cost of capital for the company, you wouldn’t know what the company would be valued at.
Imagine the company sells clothes across the rural parts of India, to 10m customers. What would Ferrari buy it for? The answer would be the value of £1m per year, discounted at Ferrari’s cost of capital, and minus the costs of handling that money, like accountants’ fees.
What about Unilever? They want access to customers across rural India for their products, and buying this company would mean they could sell an extra £1 of goods to each of the 10m customers each year. The value of the company to Unilever is much more than the value to Ferrari.
The point is that even for a company with defined cash flows, the concept of value is not fixed. As in any other market, price is a function of supply and demand. Nevertheless, there are some methods that investors use to start from.
DCF. Discounted Cash Flow. The present value of all expected future free cash flows, discounted at the weighted average cost of capital. Meaningless for a small company, and even more so because there is a McKinsey version, Abnormal Earnings Growth version, Residual Income version…
Book Value. On paper, what is the value of all the assets of the company, minus the value of all the liabilities. For example, you have a factory and some machines worth £2m and some IP worth £0.5m, but debt of £1m, so a valuation of £1.5m. This doesn’t work well for IP-based companies, as the IP hasn’t been valued yet, nor does it for tech companies, as they don’t have assets that are valued like real assets are. It also takes no account of growth, so is harsh on growing startups. It should be seen as an absolute bottom line for most startups.
Revenue Multiple. Look at the valuation of other companies in this sector, and divide it by their revenue. This give you a multiple that you can multiply this company’s revenues by, to get its value. For example, if everyone else in the sector is valued at around 2x revenue, then if you have revenue of £100k, your value is probably £200k. The problem here is that the multiples will probably come from larger companies, who may have different costs associated with their size, and again there is no accounting for growth.
EBITDA Multiple. The same as a revenue multiple but calculated using EBITDA, which controls for some of the costs associated with the specific company. The problem here is that a young company may have zero, or even negative, EBITDA, making the calculation meaningless.
Market Share. You could define the valuation of the entire market, then work out what share of it you would reasonably get, and multiply the two together. If it’s a new market, you could work out the revenues expected from the whole, deduct costs, and then use the DCF model.
Make It Up. This is what will actually happen. The more credible you sound, and the better your presentation, data to support assumptions, team, plan and so on, the more weight will be given to your made-up valuation. Higher offices, bigger meeting room, non-refillable bottles of sparkling water, and the investor wins.