Super angel investor Ron Conway said, “I think it’s important for the founder to say to themselves in the beginning, at what point does my ownership start to demotivate me?”
Spotify struck new agreements with investors that force them to issue more shares the longer they waits to go public, diluting the shares of the original owners. Beepi, an online used car e-commerce startup, shut down in February after running out of funding.
Today’s investors are pickier. They want to see profits. They demand better terms at startup founders’ expense. The more money your company needs, the more pressure you will feel to accept investors’ demands.
The most important terms in any round of investment is how much money and for what stake of the company will the venture capital firm invest. When a venture capital says “I’ll give 5 million for 10% of the company”, does that mean that your startup is currently valued at $50 million?
The answer is no; not yet. If your investor pays $5 million for 10% of your company, the post-money valuation is indeed $50 million but not your pre-money valuation. Understanding the difference between pre-money vs. post money valuation is critical.
To better prepare you for negotiations, learn the basics of startup valuation.
Pre-money refers to a company’s value before it receives the latest round of financing, while post-money refers to its value after the funding event. Investors often speak of investment in terms of post-money valuation. What they’re really saying is “I’ll invest 5 million for 10%, which will in effect increase your company valuation to $50 million.”
To calculate post-money valuation, simply divide the new investment by the percentage of ownership the investor is getting. In the example above, divide $5 million by 10% to obtain $50 million.
Pre-money valuation is the valuation of your company before the capital injection. To calculate the pre-money valuation you have to work backward from the proposed deal terms.
In our example, subtract $5 million (the investment amount) from $50 million (the business’ post-money valuation) and you will get $45 million as the pre-money valuation.
Valuations with Stock Options
As we’ve said, stock options can be powerful tools to motivate employees. But be aware that your investors may require the inclusion of unallocated stock option pool (set aside for employees) in their pre-money valuation.
Don’t be fooled about stock option pool. It’s just another way for the investor to get better terms by lowering the valuation. It is all about price.
Adding unallocated option pool has the effect of greatly lowering the pre-money valuation as well as diluting your own shares.
Back to our example, suppose the investor’s $45 million pre-money valuation includes an option pool for employees equal to 20% of the post-money valuation. This means the investor effectively valued your company at $35 million and require the creation of $10 million worth of options (20% of $50 million).
That option pool is worth 22% of your pre-money valuation. This swallows a significant portion of your pre-money valuation and dilutes the value of your shares and those of your co-founders – but naturally, not the investors’.
Getting a Fair Deal
Landing a meeting with investors and pitching your idea to them was hard enough. Negotiating a fair deal can be harder.
Investors can ask for too much stock or give you a valuation you don’t agree with. They can write agreements with you that seem fair on the surface but will eat away at your ownership. Be on the lookout for the size of the unallocated option pool.
The startup lawyers at Buchwald & Associates can guide you in your negotiations with investors and help you take in an angel or VC investment on the best of terms. Call us to get the insight you need.