Throughout the series of modeling posts, I’ll be using the example of Sweet Co. because Canaan, the venture firm where I am an analyst, likes investing in sweet companies.
The founders of Sweet Co. own shares in the company. They decided to make things easy and start with 1,000,000 shares of Sweet Co.
At a certain point, Sweet Co. needs more money than the business generates on its own, so the founders decide to raise $500k of venture capital. From an entrepreneurs’ perspective, the process of finding an investor is a combination of art, hard work and luck – and though it’s important – it’s already covered in various places on the internet.
Assuming the founders of Sweet Co. have found an interested VC, the first thing that the VC and Sweet Co. have to agree upon is the valuation of the company immediately before the VC makes an investment. This valuation is called the pre-money valuation because it’s the value of the company immediately before the VC invests their money.
The reason that this is important is because the pre-money valuation has a direct effect on how much of the company the founders need to sell to get that $500k. If the company’s value is set at $100mm, then the founders only need to sell a small part of the company (think less than 1%). That’s good for the founders because they retain most of their ownership. On the flip side, if the value of the company is to be only $100k, then the founders will have to give up a large portion of the company (think 50%+). Don’t worry, there is a sample workbook attached to this post that will allow you to see the math.
Surprisingly, determining the value of a seed deal (usually under $1mm) or Series A stage deal (usually $1-3mm) has less to do with determining value and more to do with structuring an appropriate amount of ownership dilution for the founders. In this sense, valuation is less of a science and more of an art (though art that requires lots of math).
1.) As a rule of thumb, most early stage VC investors (including Canaan) want to own at about 20-30% of any company they invest in – which means the founders’ ownership will be diluted by 20-30%. (In reality, VC’s often don’t want to own a huge percentage of an early-stage startup because investors want the founders to be motivated by their equity stakes)
2.) Most of the time, entrepreneurs have a rough idea for the amount of money they need to raise – in our case it’s $500k.
With these two inputs, we can back solve a pre-money valuation that satisfies both the entrepreneur and the investor. In the case of a $500k raise and a 25% ownership requirement by the VC, the pre-money needs to be $1.5mm – a fairly typical seed stage valuation for a company.
See the attached work book to understand how the math for all of this stuff works. Try playing around with different raise amounts and different pre-money valuations. You’ll quickly see why pre-money valuation is so often talked about by both investors and entrepreneurs.