Why is there so much hype over post-money valuation? In the startup world, the bigger the post-money valuation, the better. The unwritten rule is for a startup to obtain unicorn status, with a post-money valuation of $1 billion or more. But what is post-money valuation? When a startup receives investment from outside investors like venture capitalists and angel investors, two equity valuations are essential. These are the pre-money, and post-money valuations that refer to the company’s value before and after an investment are done. These valuations determine how much ownership external investors receive when they make a cash investment into a company. The post-money valuation is always greater than the pre-money valuation as it is the value after a cash injection is made. This article will discuss the post-money valuation formula in detail with illustrated examples and suggest some online post-money valuation calculators.
Post-Money Valuation Calculator Formula
The Corporate Finance Institute gives us the formula for the post-money valuation below:
The post-money valuation formula is straightforward and is applied for every round of funding (Series or Round A, B, C, etc.). In our previous article on Pre-Money Valuation Calculator, we also presented the following basic formula for both post-money and pre-money valuation:
The Difference Between Pre-Money And Post-Money Valuation
As the name implies, the difference between pre-money and post-money valuation is in the timing of the valuation. Pre-money is equity valuation before funding, while post-money is after receiving funding. In funding startups, especially in the early stages, both values are important metrics as the values could dramatically change after a funding round.
Sample Calculation of Post-Money Valuation
Here’s a sample calculation from the Corporate Finance Institute:
If we break down this sample calculation into its component parts #1, #2 and #3:
The pre-money equity valuation of $50 million with 1 million outstanding shares before the round of funding. If we calculate the share price, we have:
Share Price = $50,000,000 / 1,000,000 = $50
In the round of funding, it will raise $27 million of new equity at the pre-money valuation of $50 million, the resulting newly issued shares:
Shares Outstanding = $27,000,000 / $50 = 540,000 new shares.
The $27 million cash raised (assuming no transaction costs) is added to its pre-money value of $50 million; hence, the post-money valuation is:
Post-money Valuation = $50,000,000 + $27,0000,0000 = $77,000,000.
After the transaction, it will have 1.54 million outstanding shares, maintaining its share price at $50.00.
If we look at it in terms of equity and enterprise values, the enterprise value remains the same, and the equity value post-money is higher than pre-money:
Dilution Of Shares
After a round of funding, the original shareholder’s proportional ownership will be diluted due to the issuance of new shares. From the example above, the founders had 350,000 shares before the Series X funding. This represented 35% of the total shares. After the funding, they still retain their original 350,000 shares, but these will now represent 23% of the total shares. The value of their shares remain the same:
350,000 x $50 = $17, 500,000
The Difference Between Enterprise Value And Equity Value
It is important to note the difference between the enterprise value and the equity value. The enterprise value is the value of the entire company without capital structure in consideration. It is not affected by a round of funding. It would remain the same even if the post-money equity value increases by the amount of cash received after a round of funding. Another way of putting it is that enterprise value is the value of the core business operations available to all shareholders -whether they be debt, equity or preferred shares and many others. In contrast, equity value is the company’s total value available to only equity investors like venture capitalists and angel investors.
Here’s an illustration of how the equity value can be derived from the enterprise value, according to the Corporate Finance Institute:
In the same manner, the enterprise value can be calculated from the equity value by the following formula:
Except for banking and insurance industries that use only equity value, both equity value and enterprise value are used in the valuation of companies. What is important is understanding when to use which in the valuation of companies. This will depend on the metric used to value a company.
Equity value is used when the metric includes the net change in debt, interest income, and expense. If none of these is included, then enterprise value is used. Enterprise value is used before any interest or debt has been withheld because that cash flow is available to both debt and equity shareholders.
Enterprise Valuation Methods
As can be seen above, the enterprise value affects the equity value. When a company undergoes funding, it needs to reach a consensus with investors about its enterprise value. Although there are widely used valuation methods like discounted cash flow (DCF), this process is often subjective and controversial, compared with other companies in trading multiples or public companies and precedent transactions. Let us look at the overview of these three valuation methods from Corporate Finance Institute:
From the above diagram, the Cost Approach considers the costs to rebuild or replace an asset. It is used in valuing real estate like commercial properties, new construction, properties for particular purposes. The Market Approach is a kind of relative valuation often used in the industry and comprises making comparisons with public companies and looking at previous transactions. The most comprehensive of the three methods is discounted cash flow (DCF), a valuation based on the underlying cash flow. In the DCF, an analyst forecasts the business’ unleveraged free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).
Post-Money Valuation Calculator
Like the pre-money valuation, many online platforms have post-money valuation calculators like Equidam or online calculators like Omni Calculator. Platforms like these enable users to input data and track valuations between rounds. Equidam has a dashboard feature that enables users to record transactions and financials. The dashboard gives reports such as the status of the valuation. This will allow tracking and transparency in the funding rounds and decision making.
Understanding Valuation Gaps
A company’s value is often hotly contested. Overly optimistic founders can have exaggerated business expectations, resulting in biased and inflated valuations. As a result, Venture Capital (VC) firms will typically ask for preferred shares to mitigate and bridge this valuation gap.
The Corporate Finance Institute notes that by getting preferred shares (in place of common shares), VC firms obtain many advantages:
- If the company is sold, they are paid first.
- They are given preferential rates of return.
- They have the option to participate first in subsequent rounds of funding.
- They can stipulate against dilution of their shares.
As preferred shares are worth more than the common shares, VC’s can purchase them at the common share price, resulting in a clear advantage. In turn, this makes their returns on investment more attractive.
The Hype Over Post-Money Valuation
Sky-high valuations are always a favorite topic when it comes to startups. Mention venture capital funding, and almost always, the news is followed by post-money valuation questions (PMV). The higher the PMV, the more the startup is deemed attractive. It is common knowledge that among startups, one of the goals to achieve is to reach the “unicorn” status – meaning a post-money valuation of more than $1 billion. There is always a running list maintained by major publications of startups that have become unicorns after a funding round. If the startups participated in an incubation or acceleration program, you are sure to see their unicorn status highlighted under the incubator or accelerator’s success statistics.
But is post-money valuation all it is hyped to be?
If we examine the calculation of PMV, the share price paid in the most recent fundraising round is multiplied by the fully diluted number of outstanding shares. This concept is simplistic. It assumes that all shares of a firm are the same, which may be the case in most publicly traded firms but not in VC-backed firms. VC-backed firms usually have a range of different share classes like common and preferred shares, subject to different contractual rights. These share classes may differ in general share type. If you apply the share price of the most recent financing round to all outstanding shares, both specific structures and contractual rights are not considered, resulting in a substantial deviation of post-money valuation from the company’s fair value.
This deviation is the subject of research from Stanford, showing that the post-money valuation of US unicorns is on average 51% higher than their true worth. The author of this study, Professor Strebulaev, stated that some unicorns make generous promises to their preferred shareholders, making their common shares nearly worthless. With this potential deviation from the firm’s actual worth, all stakeholders of the VC ecosystem must have a thorough understanding of post-money valuations and their limitations.
How do founders and investors overcome this hype over PMV? By using more advanced analysis, taking into consideration, the different asset classes, firms can analyze the share structure of their firm. By doing this, firms can model the conversion points of the various share classes and derive their payoff structure. VC’s, founders and other shareholders can also do a scenario analysis to help in decision-making during periods of uncertainty which is a common occurrence, especially in the rapid development environment of startups.
Final Thoughts On Valuation
As can be seen, valuation is not a simple matter. Although it can be done in-house using tools such as a post-money valuation calculator, and especially if someone in the team has a solid financial background, caution still needs to be exercised. Founders can enlist the help of financial consultants specializing in valuations. If not to calculate the valuations for them but at least check their calculations. In recent years, there have been calls for VC’s and investors, in general, to be transparent in their funding transactions. A lot of VCs publish their terms of investments and contracts. Several also open about reaching a consensus on company valuation, especially if the startup is dealing with cutting-edge technologies or when the addressable market size is huge.
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