For every complex problem, there is an answer that is clear, simple, and wrong.
A century ago, journalist H.L Mencken first wrote those words, and it continues to be true when we discuss investments and valuations in private companies in terms of a pre-money and post-money valuation. This valuation method is common to use because it is clear to understand and simple to calculate.
Unfortunately, it also provides little insight into the actual market value of a private company. This has big implications because the following conversations are confusing at best and frustrating at worst:
Founder: We’re raising a $1M at a $4M pre valuation.
Investor: Ok, prove you’re worth $4M pre.
Founder response: (looks_confused), or: well, our cash flow in year 3 is bla bla bla, and our exit in year 6 is bla bla bla, so we’re $4M.
Reality: Venture capital is a VERY risky business. The correct valuation could be anything between $0 and $50M. Uber would’ve been a cheap investment at $100M even at day 1. Theranos on the other hand, an expensive investment, even at $10K. There’s no way to “prove” a valuation without building assumptions on a house of cards.
Investor: I don’t “think” you’re a $4M pre.
Founder response: Well, this is where the market is.
Reality: If venture capital is complicated and risky (and it is), the investor can’t actually know what EXACTLY the value is. Also, there is no “market” for early stage companies. This is why thesis investment (i.e. macro movement or time) trumps other factors.
Investor: I think $4M is too expensive.
Founder response: Well, XYZ just raised [insert_more_money] at [even_higher_valuation].
Reality: “Expensive” is a relative term, see variation 2 above, and no two early stage companies are the same, so this is just playing off of FOMO, not valuations.
The pre-money and post-post valuation framework is widely used, and awfully wrong, which makes for odd conversations (like the ones above).
The simplicity of this valuation methodology is fine, but as a founder, focus on this:
- 1. The framework has little to do with an actual valuation for early stage startups.
- 2. Don’t try to “convince” anyone of mathematics of your pre-money calculations.
- 3. Focus on the amount that you’re raising and show how it’s going to help you increase the “value” of your company by 3x in 18 months, and again 3x in 18 months after that, and then 3x every 18 months after that. Your job is to do as much as possible with as little as possible (i.e. looking for high yield)
- 4. At the first institutional round, expect to give away 25% - 30%.
- 5. You don't actually "own" the pre-money.
If you can nail down #3 above and convince investors that you can deliver on the promise, your Post-money valuation is #3 / #4, and your Pre-money is Post-money valuation less amount stated in #3.
The real question becomes, “can you convince investors that you’re worthy of their money to prove out #3?” After seeing a few thousand venture-backed startups, we can help you answer this question before going in front of an investor. Send us a note at firstname.lastname@example.org and let's talk.