Venture Capital Terms: Valuation

Purchase priceA company’s valuation at the time it receives venture capital financing is probably the most important factor influencing the outcome of a deal. Although some semi-quantitative methods for valuing a startup company are used, the valuation is largely a product of negotiation between the company and the investors. If a VC can negotiate a smaller valuation on a term sheet, it means they can purchase a larger percentage of the company for their investment.

Although multiple terms exist for discussing a company’s valuation, they are all derivable from one another, and are thus really just different ways of expressing the same underlying valuation.

 

 

  • Price per share: The price per share is perhaps the most familiar valuation term to those used to dealing with public companies. As in the stock market, the share price is the price paid by the VC for each share purchased. Thus, the number of shares purchased by a VC can be computed as the amount of the investment divided by the price per share.
  • Pre-money valuation: The pre-money valuation is defined as the value of the company prior to the financing. It can be computed as the price per share multiplied by the number of shares outstanding before the current round of financing.
  • Post-money valuation: The post-money valuation is defined as the value of the company after the current round of financing. It is calculated as the pre-money valuation plus the amount invested in the current round.

 

How the terms are related

It should be clear from the above definitions that these three valuation terms are very closely related, and have a very important impact on the deal’s outcome for the VCs as well as the common shareholders. For example, suppose a company has 1M shares outstanding and is raising a series A. Let’s further suppose that the VCs are investing $4M.

At a negotiated share price of $1, the investors will purchase 4M shares. This means that the investors will own 80% of the company (4M out of the total outstanding 5M shares). It also means that the implied pre-money valuation of the company is $1M (1M shares outstanding before the financing times the $1 share valuation). The post-money valuation in this case would be $5M: the $1M pre-money valuation plus the $4M investment.

Now suppose that instead of the above $1M pre-money valuation, the company successfully negotiates a $2M pre-money. This means that the price per share is $2 (1M outstanding shares before the financing, valued at $2M). It also means that the $4M VC investment will only buy 2M shares, or roughly 66.7% of the company.

 

Summary

  • The negotiated valuation on a VC term sheet has a huge impact on the deal value for the investors and the common stockholders.
  • There are multiple ways of expressing valuation (pre-money, share price, post-money), but they all express the same underlying company value.