When a company decides that it must raise capital, a key question that must be answered is how much the company is worth. For example, if the business needs $500,000 to get started and/or grow, how much of the equity in that company should $500,000 command? Once this question is answered, the company will go out and try to find investors. When doing so, a key question often arises as to whether the valuation is “pre-money” or “post-money.”
“Before the money” or “pre-money” and “after the money” or “post-money” denote simple concepts. However, these simple concepts can even confuse even the most sophisticated analysts at times. If a company is valued at $1 million on Day 1, then 25 percent of the company is worth $250,000. However, there may be an ambiguity. Suppose the company and the investor agree on two terms: (1) a $1 million valuation, and (2) a $250,000 equity investment. In this case, the company may offer the investor 250 shares for $250,000. Immediately there can be a disagreement. The investor may have thought that equity in the company was worth $1,000 per percentage point, in which case $250,000 gets 250 out of 1,000 shares or a 25% equity position. Conversely, the company may have believed that the investor was contributing to the enterprise which was already worth $1 million. Under this rationale, the $250,000 would give the investor 250 shares out of 1,250 shares or a 20% equity position.
The critical issue was whether the agreed value of $1 million to be assigned to the company was prior to or after the investor’s contribution of cash (pre-money) or post-money.
In the above case, a pre-money valuation of $1 million and a post-money valuation of $1.25 million were equivalent. Because mixing up the terms could significantly increase the cost of capital raised, companies must be sure to understand the two metrics and agree with investors to the metric that raises them the capital at the appropriate price.