Posted by Neha De
July 16, 2020 | 5-minute read (850 words)
If you’re looking to raise funds for your business, there are certain funding terms that every entrepreneur must learn — two of the most important ones being “pre-money” and “post-money.”
You’re likely to hear these terms many times during a venture capital (VC) investment round, whether in your capitalization table, term sheet (a non-binding preliminary agreement that serves as a starting point for detailed negotiations required for a contract) or while negotiating with potential investors. As a founder, you must understand what these words mean, as they impact the valuation and financing of your company.
What is Pre-Money?
A company's pre-money valuation refers to the value of an organization excluding the latest round of funding or any other external funding. In simple words, it is how much a company might be worth before it starts receiving any investments. This valuation gives investors an idea of the current value of the business and also provides the value of each issued share.
What is Post-Money?
Post-money valuation refers to how much the company is worth after it receives capital and investments into it, including the latest capital injection or any other outside financing.
Adding money to a company’s balance sheet increases its equity value. Therefore, the post-money valuation is always higher than the pre-money valuation.
Pre-Money Vs. Post-Money
Knowing the difference between pre-money and post-money valuation is important because it defines the equity share that the investor(s) will be entitled to, after the funding rounds. Let's take an example. Suppose an investor is looking to invest in your startup, and you and the investor both agree your company is worth $1 million so the investor decides to put in $300,000.
The ownership percentages for you and the investor will depend on whether this $1 million valuation is pre-money or post-money. If it is pre-money, your company will be valued at $1 million before the investment comes in. Whereas, after the investment, it will be valued at $1.3 million. That’s because if the $1 million valuation includes the $300,000 investment, then it is referred to as post-money valuation.
Some Other Associated Terms
When you're dealing with corporate finances, it might also be helpful to know a few additional funding terms, as follows:
Common Stock: Also called voting shares or ordinary shares, common stock is a representation of owning part of a company in the form of equity ownership. It's a type of stock that gives partial ownership and voting rights in a company during corporate shareholder meetings. The amount of ownership equals the amount of common stock a person owns compared to the amount issued.
Preferred Stock: Preferred stock is a special class of equity that adds debt features. Just like common stockholders, preferred shareholders receive a share of ownership in an organization. They also receive special rights, including guaranteed dividends that must be paid out before dividends to common shareholders and priority in case of liquidation. Preferred stock is listed separately from common stock and trades at a different price than common stock.
Liquidation Preference: Liquidation preference is offered to an investor as part of the preferred stock. Venture capitalists are almost always given preferred stock as equity. Liquidation preference offers investors priority for payout when the company is either bought out or goes bankrupt. Once the shareholders receive their cut, the next individuals to get money from the liquidation of the company are the preferred stockholders.
There are three types of liquidation preference:
- Straight or Non-Participating, which is typically the ideal option for a company. In the event of liquidation, the preferred stockholders can either receive their initial investments back plus accrued dividends, or they can convert their shares into common stock and be treated as common stockholders. Common stockholders share in the remaining money.
- Participating, which is usually ideal for the investor. As with non-participating, the investor gets back their investment plus accrued dividends. The investor is also treated like a common stockholder and is therefore usually paid twice.
- Capped or Partially Participating, which has all the features of the participating preference, except that the amount of money the investor receives is capped. Once the investor receives the capped amount of money, they cannot usually get any more.
Convertible Note: A convertible note is a type of debt that converts into equity in exchange for an investment rather than being operated as a traditional loan, which is simply paid back with interest.
Round Size: The amount of money a company receives from a round of investment is called the round size. It’s essential to think about more than just the round size when going into an investment round, in terms of what the investors bring to the table besides money. It’s also important to consider the terms that the money is taken on, such as the total equity being given up.
Option Pool: The amount of stock set aside for future employees and investors is known as an option pool. It can be thought of as the percentage of a company the owner is willing to give away in the future.