As an early-stage entrepreneur, one of the first things you learn is that the valuation of your company is important. Every Shark Tank episode focuses on the drama and negotiations around valuation. In fact, the beginning of every Shark Tank pitch starts off in the following way:
Entrepreneur: “I am seeking a $## investment in exchange for a ##% equity stake in my company.”
One of our newest portfolio companies, Packback, actually experienced this first hand on Shark Tank when they negotiated and struck a deal with Mark Cuban.
But if you’re just starting, or even been in the game awhile, it’s important to know there’s more to valuation than standing in front of an investor and asking for $## in exchange for ##% equity stake.
In a nutshell, valuation is the financial worth assigned to a business. This sounds simple enough, but you have to remember there are layers to measuring valuation. Let’s dig in deeper and look at a scenario where a company is taking on its first investment capital since they started the business.
Pre-Money and Post-Money Valuation
However, to begin, let’s take a moment to define the two different ways valuation is defined.
Pre-Money Valuation: The valuation of the company right now, prior to investment.
Post-Money Valuation: The pre-money valuation plus the total investment amount.
The Pre-Money Valuation is determined based on a number of factors involving the stage of the business and is negotiated between the entrepreneur and the investor. Additional details on Pre-Money Valuation will be covered in a future blog post.
The Post-Money Valuation is determined based on a mathematical equation outlined below.
Pre-Money Valuation + Total Investment Amount = Post-Money Valuation
Example: $4M (Pre-Money Valuation) + $1M (Total Investment Amount) = $5M (Post-Money Valuation)
Let’s go a layer deeper to understand how this valuation is being measured based on price-per-share, or the price for each share of stock in the company.
Where does the first set of shares come from? Every company has a certain number of shares, which is how valuation is calculated. When a company is first formed, shares are created and issued to the founders. The number of shares originally issued at the formation of the company is arbitrary, but provides the foundation for all future shares.
Since the number is arbitrary, this means the shares originally issued are up to the founder’s discretion, whether that’s 100 shares, 3M shares, 8M shares, etc. There are some best practices around how many shares to issue in order to make the math easier, but generally speaking the number of shares originally issued is arbitrary. As the company takes on additional investment, more shares are added based on a calculation that we will review further in the next section.
Now that we have a better understanding of shares, lets continue with our example of a company receiving their first investment capital. Let’s say the founders decided on 8M shares, which we will now refer to as Pre-Money Shares.
Now we have enough information to calculate the price-per-share.
Pre-Money Valuation / Pre-Money Shares = Price-Per-Share
Example: $4M (Pre-Money) / 8M (Pre-Money Shares) = $0.50 (Price-Per-Share)
Number of Shares
Now that we know the price-per-share, we still need to determine the number of new shares that are issued to the investors. So, how many shares will investors receive for their $1M investment? The formula for calculating number of investor shares is shown below.
Total Investment Amount / Price-Per-Share = Investor Shares
Example: $1M (Total Investment Amount) / $0.50 (Price-Per-Share) = 2M Investor Shares
As seen in the example above, investors will receive 2M shares for their $1M. Now that we know the number of shares to investors, we must now calculate the total Post-Money Shares, which reflects the total number of shares the company will have after the investment.
Pre-Money Shares + Investor Shares = Post-Money Shares
Example: 8M (Pre-Money Shares) + 2M (Investor Shares) = 10M (Post-Money Shares)
So, the total number of shares the company will have post investment is 10M.
The last layer is how to calculate the percent ownership for investors and entrepreneurs. As we saw in the Shark Tank example, the entrepreneur is offering a percentage equity stake in their business.
There are two ways to calculate Percent Ownership for the investors.
1. Investment Amount / Post-Money Valuation = Investor Percent Ownership
2. Investor Shares / Post-Money Shares = Investor Percent Ownership
1. $1M (Investment Amount) / $5M (Post-Money Valuation) = 20% (Investor Percent Ownership)
2. 2M (Investor Shares) / 10M (Post-Money Shares) = 20% (Investor Percent Ownership)
As you can see, the percentage ownership comes out to be the same.
Comparing Percentage Ownership
When comparing the percentage ownership for Pre-Money and Post-Money one needs to put together the information we have calculated above. Once that is complete, the comparison can be seen below.
In summary, there are many layers to measuring valuation. Here’s a recap of the formulas we have discussed are outlined below.
These formulas will help you determine your valuation and equity stake, but they won’t tell you whether you should be raising, or whether you’ve over or under-valued your company. Understanding the competitive landscape and the market, as well as your company’s own value, key metrics, and trajectory for success, are just as important, if not more so, as getting your math right. That’s why being thoughtful, reasonable, and discerning when determining your pre-money valuation is a crucial step — and why considering whether you’re even ready to raise is the most important.
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About Hyde Park Angels
Hyde Park Angels is the largest and most active angel group in the Midwest. With a membership of over 100 successful entrepreneurs, executives, and venture capitalists, the organization prides itself on providing critical strategic expertise to entrepreneurs and the entrepreneurial community. By leveraging the members’ deep and broad knowledge of multiple industries and financial capital, Hyde Park Angels has driven multiple exits and invested millions of dollars in over 30 portfolio companies that have created over 680 jobs in the Midwest since 2007.
About the Authors
Michael Sachaj is the Associate Director of Hyde Park Angels. He leads HPA’s investment opportunities through sourcing deals, conducting due-diligence, and providing oversight of the University of Chicago Booth Associate team. Michael joined Hyde Park Angels after spending three years as a strategy consultant with Booz Allen Hamilton in Washington, D.C. where he worked on a variety of process and customer service improvement efforts. He earned a BA in Political Science from Northwestern University in 2009.
Alida Miranda-Wolff is Associate Manager at Hyde Park Angels. Her role includes creating and executing marketing and communications strategies, planning and managing events, fostering and maintaining community and industry partnerships, and managing membership. Prior to joining Hyde Park Angels, Alida served as a manager, data analyst, and publication specialist at a multibillion dollar industrial supply corporation. She has led one of the most successful Kickstarter campaigns in Chicago history and worked with half a dozen startups in various marketing, content creation, and project management roles. Alida believes in creating valuable, spreadable multimedia content, and has done so as a freelance writer for several print and online publications.
Amutha Muthumukar is a marketing intern at Hyde Park Angels. Her role is to assess analytic tools and develop strategies to further HPA’s social media campaign. She also works to maintain community relationships and increase HPA’s community engagement. Previously, she has worked with startups on redesigning social marketing campaigns through data analysis.
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