How much of your company will investors really own after funding? What determines your startup’s worth in the eyes of venture capitalists?
In their book Venture Deals, Brad Feld and Jason Mendelson break down the essentials of pre- and post-money valuation in venture capital deals. Understanding these concepts helps founders navigate negotiations and avoid surprises about ownership stakes after investment.
Keep reading to learn how different valuation theories affect what VCs think your company is worth—and how to pitch your startup accordingly.
Pre- and Post-Money Valuation
Feld and Mendelson say pre- and post-money valuations are key components of the term sheet. Pre-money valuation is what VCs think your company is worth before they invest. This valuation depends on factors like founder experience, industry, product potential, intellectual property, economic conditions, and interest from other investors. Post-money valuation is the company’s value after the investment.
The authors warn, however, that VCs might have a lower pre-money valuation in mind than you have for your company, which could result in them owning a larger post-money share of your company than you expected. For example, say you’re the founder of a tech startup that you believe is worth $2 million before any investment (your pre-money valuation). You’re seeking a $500,000 investment from a VC, for a post-money valuation of $2.5 million. In this scenario, you’d expect the VC to own 20% of your company post-investment ($500,000 is 20% of $2.5 million).
However, after negotiations, the VC’s final offer might estimate your pre-money valuation at only $1.5 million based on their assessment of factors like market size or competition. This would put the post-money valuation at only $2 million. If they still invest $500,000 based on that lower pre-money valuation, they’ll own 25% of your company post-money ($500,000 is 25% of $2 million)—not the 20% you initially expected.
| Malkiel’s Theories of Valuation In A Random Walk Down Wall Street, economist and financial executive Burton Malkiel writes that there are two main theories of a stock’s valuation: the firm-foundation theory or the castle-in-the-air theory. Investors might evaluate your company’s value differently, depending on which theory they follow. Malkiel writes that the firm-foundation theory says that assets have an “intrinsic value” based on their present conditions and future potential. The firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its current dividends and (2) the estimated growth of its dividends in the future. Once an intrinsic value is established, the investor will make buying and selling decisions based on the difference between the actual price of the stock and the intrinsic value (because, according to the theory, the price will eventually regress to the intrinsic value). The castle-in-the-air theory of asset valuation, on the other hand, holds that an asset is only worth what someone else will pay for it. No asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth. In other words, a castle-in-the-air investor makes her money by investing in stocks she thinks other investors will value. As an entrepreneur, understanding these theories can help you adapt your pitch and negotiation strategy to align with how VCs assess value. For example, if a VC leans toward the firm-foundation theory, focus on your company’s current revenue, profit margins, and projected growth to demonstrate intrinsic value. On the other hand, if they follow the castle-in-the-air approach, emphasize market trends, your brand’s momentum, and the potential to capture investor excitement. |
Exercise
VCs might value your company lower than expected, allowing them to take a larger ownership stake. How would you defend your company’s valuation during negotiations while keeping a good relationship with potential investors? What metrics or growth indicators would you focus on to support your case?
