In the startup world, where every decision counts, we often see a company’s valuation take center-stage, serving as the fundamental barometer of a company's worth and how equity is distributed among founders and investors. In the context of valuation, two terms frequently cross paths, “Pre-Money” and “Post-Money” valuation. While the terms may appear similar at first glance, their subtle differences have important implications and can leave a lasting impact on the cap table (which outlines the ownership structure of a company, including details about shareholders, their ownership percentages, and the type of shares they hold). This article aims to elucidate these concepts, enabling founders to thoroughly assess and comprehend the consequences.
First things first, what exactly is valuation? A simple analogy can help get the idea across. Imagine your startup as a pizza. Valuation is like figuring out how much the whole pizza is worth, and equity or dilution is about deciding how big a slice of that pizza (% of your company) you're willing to share with investors in exchange for their funding.
When discussing valuations, it is common to base it on either Pre-Money or Post-Money valuation, which is to say that only one is used as the basis and its value is fixed while the other is computed using the formula below, rearranging as needed.
Here Capital Raised (“Money”) refers to the capital invested by incoming investors in the current investment round.
So if a startup raises US$2Mn at a valuation of $US 6 Mn on a Pre-Money basis, then this US$ 6 Mn refers to the Pre-Money valuation with the Post-Money being $US8Mn (US$6 Mn + US$2Mn).
If the raise was on a Post-Money basis, then the US$ 6 Mn would have been the Post-Money valuation with the Pre-Money being $US 4 Mn (US$ 6 Mn - US$2Mn).
One of the primary purposes of valuation is to determine the allocation of equity to incoming investors and, consequently, the extent of dilution experienced by existing shareholders when new capital is invested (this article does not intend to cover how startups are valued and assumes that the valuation, either Pre or Post, is already determined). When calculating equity ownership or dilution, it is crucial to remember that Post-Money valuation is always used. This decision is logical because without the infusion of new capital, there is no need to calculate dilution or assess equity ownership and since only Post-Money accounts for the new capital (hence the prefix “Post” which means “After”), it is the one used. So if,
The equity ownership / dilution percentage then comes to 33% [US$ 2 Mn divided by US$ 6 Mn].
If the above was done on a Pre-Money basis, then the Pre-Money valuation would have been US$ 6 Mn. Since Post-Money valuation is used to calculate equity ownership / dilution, we first need to calculate it using the formula mentioned above.
As per the formula, the Post-Money valuation is the sum of Pre-Money (US$ 6 Mn) and Capital Raised (US$ 2 Mn), resulting in a total of US$ 8 Mn. Therefore, the equity ownership or dilution percentage is now 25% (US$ 2 Mn divided by US$ 8 Mn) instead of 33% above.
One key observation is that, on a Pre-Money basis, the Post-Money value is not fixed and is determined by taking into account both the Pre-Money value and the Capital Raised amount. As a result, the Post-Money value tends to move in tandem with the non-fixed of the two values i.e Capital Raised - increasing as it increases and decreasing as it decreases. On a Post-Money basis, the Capital Raised amount does not have any effect on the Post-Money value as it is already fixed.
This dynamic characteristic of the Post-Money value in response to Capital Raised, when using Pre-Money as the valuation basis, forms the core principle that contributes to the divergent impact of the two bases on the cap table.
In summary, determining the Post-Money value is key for calculating Equity Ownership or Dilution, whether a Pre-Money or Post-Money basis is used. If the basis is Pre-Money, then the Post-Money valuation needs to be computed using the Capital Raised amount. If it is on a Post-Money basis, then no additional computation is required and that figure can be used directly.
So what happens when the round remains open for months and the exact amount of capital to be raised cannot be determined beforehand - a typical scenario where founders cannot predict the exact amount the company will end up raising due to varying market conditions, investor interest, and appetite.
Take the case where Pre-Money is used as the basis for valuation, which as mentioned above means discussions are based on it and it remains fixed. However, since equity ownership and dilution depend on Post-Money, it first needs to be computed by taking into account the actual amount of capital raised, which can only be ascertained after the round closes.
In this situation, there are effectively three scenarios that can play out:
The effect on the cap table depends on the type of scenario transpiring and the valuation chosen as the basis. The effect is captured in the following table (for comparison purposes, both the Pre and Post valuation basis show a Post-Money Valuation of $US 6 Mn for the Fully Subscribed scenario):
The table above shows how the Post-Money valuation is dependent on the Actual Capital Raise rather than the Targeted Capital Raise. In the fully-subscribed round, where the Targeted Capital Raise and the Actual Capital Raise are the same, the Post-Money valuation is US$ 6 Mn. When the round is over-subscribed and the company ends up raising $US 3 Mn instead of the targeted $US 2 Mn, then on the Pre-Money basis, the Post-Money valuation increases to $US 7 Mn from US$ 6 Mn, with the Actual Raise added to the fixed Pre-Money value of US$ 4Mn. On the other hand, when the Actual Capital Raise is lower than the Targeted Capital Raise, the Post-Money valuation actually decreases to $US 5 Mn.
What is interesting to note here is how this changing Post-Money value affects the Price Per Equity Ownership (f) which represents the amount paid to acquire each equity percentage point (pp) by incoming investors. The Price Per Equity Ownership corresponds to the Post-Money value - increasing as Post-Money increases (from US$ 60k to US$ 70k) and decreasing as it decreases (from US$ 60k to US$ 50k). A higher value effectively means that the company is relatively (relative to the other scenarios) more valuable and incoming investors are paying a higher price for it.
When Post-Money is used as the valuation basis, the Post-Money value (a) itself remains fixed and does not need to be computed. So in the example above, the value remains unchanged at $US 6Mn for all the scenarios, regardless of the Actual Raise amount in contrast to the Pre-Money basis where the Post-Money value fluctuates. Since the valuation for equity ownership computation remains the same, the Price Per Equity Ownership (d) also remains constant at $US 60k.
So, what does all of this mean for existing shareholders (including Founders) and incoming investors? To understand this, it is helpful to compare the Equity Ownership / Dilution row for both Pre-Money and Post-Money Basis.
The table above shows that if a Founder expects the round to be under-subscribed, then a Post-Money basis is more advantageous as the Post-Money valuation remains constant at $US 6 Mn and the company dilutes only 16.7% instead of 20%.
On the other hand, if the round is expected to be over-subscribed, then a Pre-Money basis makes more commercial sense as the valuation increases to US$ 7 Mn and the company dilutes 42.9% instead of 50%.
In a fully-subscribed round, there is parity as the Post-Money value for both the bases remain the same at US$ 6 Mn, resulting in a similar dilution of 33.3%.
Another significant implication of choosing Pre over Post is that on a Pre-Money basis, incoming investors are uncertain about the exact equity ownership they will receive until the round fully closes, introducing ambiguity. In contrast, with the Post-Money basis, the valuation for equity ownership determination is fixed, and each investor knows exactly how much equity they are getting for their investment when they are subscribing to the round, regardless of whether the round is open or closed.
This article demonstrates that the answer is not that straightforward and depends on the type of scenario unfolding. In general, new incoming investors tend to prefer the Post-Money basis due to the certainty of equity ownership it offers. On the other hand, Pre-Money basis can be advantageous for founders (current shareholders) if they manage to raise more than the target, leading to an increased company valuation and less dilution.
While Post-Money valuation may result in relatively more dilution for founders in over-subscribed Rounds, they still have the option to close the round when the target is reached, that is to not raise more than the target, and thereby mitigate the dilution risk. However, this choice may come at the expense of a longer runway or accelerated growth.
Overall, many founders and investors choose to follow industry standards to expedite the negotiating process, simplify matters, and enhance transparency. Currently, the Post-Money basis appears to be the default choice, with almost 81% of all SAFEs issued on Carta in Q2 2023 in the US being Post-Money. Historically, Pre-Money was the most common way to structure investment paperwork but is now changing with Post-Money becoming more prominent for early-stage financing, especially after 2018, when Y Combinator changed its investment SAFE from Pre-Money to Post-Money.
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