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Valuation, What is it? How to calculate it?

Valuation, What is it? How to calculate it?

So do you think that your company is the next LuLu Lemon, Skype, LinkedIn?  I know, you have an idea that is so unique and no one else will ever think of it or be able to compete!  We have all been there but when seeking capital to make your fantastic idea real, convincing the angel groups, venture capital firms that their money will be well spent is a big challenge that most entrepreneurs face. 

The investment trail can lead to a series of questions but the one question that seems to stump the most well thought out entrepreneur is, What is your companies valuation?  First, the entrepreneur gives a look like the deer caught in the headlights syndrome, then the laser quick $10m, $20m or the lean back in the chair “let me get back to you later” gurgles humbly from the lips.   

The short answer to the question should be a reply from the entrepreneur to the investor, “What is the investor asking about, pre-money or post money valuation?”  The truth is, knowing this answer will allow you the opportunity to provide the possible best answer because the answer differ based on the timing of valuation. Both pre-money and post-money are valuation measures of companies. Pre-money refers to a company's value before it receives outside financing or the latest round of financing, while post-money refers to its value after it gets outside funds or its latest capital injection. Pre-money valuation refers to the value of a company not including external funding or the latest round of funding. Post money valuation, then, includes outside financing or the latest injection. It is important to know which is being referred to as they are critical concepts in valuation.

Let's explain the difference by using an example. Suppose that an investor is looking to invest in a hi-tech startup. The entrepreneur and the investor both agree that the company is worth $1 million and the investor will put in $250,000.

The ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation. If the $1 million valuation is pre-money, the company is valued at $1 million before the investment and after investment will be valued at $1.25 million. If the $1 million valuation takes into consideration the $250,000 investment, it is referred to as post-money.

As you can see, the valuation method used can affect the ownership percentages in a big way. This is due to the amount of value being placed on the company before the investment. If a company is valued at $1 million, it is worth more if the valuation is pre-money compared to post-money because the pre-money valuation does not include the $250,000 invested. While this ends up affecting the entrepreneur's ownership by a small percentage of 5%, it can represent millions of dollars if the company goes public.

This topic gets very important in situations where an entrepreneur has a good idea but few assets. In such cases, it's very hard to determine what the company is actually worth and valuation becomes a subject of negotiation between the entrepreneur and the investors.

Usually, a company receives many rounds of financing (conventionally named Round A, Round B, Round C, etc.) rather than a big lump sum in order to decrease the risk for investors and to motivate entrepreneurs. Pre- and post-money valuation concepts apply to each round.