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Preferred Shares: An Introduction
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Startup valuation is one of the most important issues faced by startup companies in their earlier years. On the one hand, these startup companies are trying to maximize their valuation while giving over a minimum amount of ownership to the investors. Investors on the other hand want to obtain the maximum stock possible. The interests of both the founders as well as the investors are heavily dependent upon the valuation of the startup firm. This is the reason that the valuation of the firm is one of the most hotly debated issues in the startup ecosystem.
It is important for every entrepreneur to have a basic understanding of how the valuation process works during startup financing. In this article, we will have a closer look at the concepts of pre-money as well as post-money valuations which are commonly associated with startup financing.
Theoretically speaking, the valuation of the same company changes at different stages. When an investment round takes place, the investors value the company and exchange their funds for shares in the company. Now, the company has a different valuation before the investment round and a different one once the investment has taken place. This is because the act of investing money in a startup ends up changing its valuation.
When an investment round takes place, cash is added to the firm’s reserves and shares are issued which reflect increased liability. Hence, both the assets as well as liabilities undergo a change leading to a change in valuation.
The valuation of the firm prior to receiving the financing is called pre-money valuation and the one immediately after the financing has been received is called post-money valuation. Pre-money and post-money valuation are important since they define the percentage of shares that are being issued to investors.
There is a widely used method that is used to calculate the post-money valuation of any firm. The method is also fairly intuitive. The amount paid by the investors is divided by the number of shares issued to the investors. This helps in finding out the value of a single share. For example, if investors have paid $100,000 for 20,000 shares, then they have valued each share at $5.
Now, this per-share value is multiplied by the number of total shares which are outstanding. Let’s assume that the firm already had 50,000 shares outstanding before the valuation. After the valuation, another 20,000 shares were added. So the total number of shares outstanding now is 70,000. Hence, if every share is valued at $5, then the total valuation comes 70,000 × $5 i.e. $350,000.
Calculating the post-money valuation is the simple part since it is a relatively straightforward calculation. Only mathematical variables need to be taken into account. The calculation of the pre-money valuation is dependent upon the calculation of post-money valuation. If the funding amount is removed from the post-money valuation, then the end result is pre-money valuation.
For instance, in the above case, if $100,000 is subtracted from $350,000, then the residual amount is $250,000. Hence, the mathematical calculation of pre-money valuation is not challenging. However, it is challenging to determine whether or not $250,000 is a fair valuation for the existing setup which the company had before the latest round of funding. Pre-money valuation is often the source of heated debates between the investors and the founders of the firm.
A down-round can be detrimental to a start-up. It is a potential indicator that the start-up firm has somehow lost the plot and is in distress. A down-round could lead to other adverse effects like employee attrition, reduction of credit period by suppliers, and so on. This is the reason why founders will almost never voluntarily agree to a down round if they have any other alternative.
The fact of the matter is that pre-money and post-money valuation are closely related. However, understanding the difference between them can be vital and can prevent the company from ending up in legal disputes.
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