Pre-money valuation refers to the value of the Company as determined by the arms-length negotiation between the Investor(s) and the Company prior to investing. It dictates the price per share of stock and the ownership stake the Investor will receive based on the amount of capital they put in. A “fully-diluted” pre-money valuation means that in determining the price per share, all issued stock of the Company will be used in the calculations, plus all stock issuable under the Company’s option pool (see paragraph following example).
Example: If the Investor offers $2 million at an $8 million pre-money valuation, they value the Company at $8 million and their investment will bring the value of the Company to $10 million after investment.
A pre-money valuation typically includes the employee option pool, which consists of unissued shares set aside for equity awards to new and existing employees. Option pools allow the Company to attract and retain talent, but they also dilute ownership, so indicating the “fully-diluted” capitalization as of the Initial Closing gives the Investors a better picture of their ownership in the Company assuming those equity awards will be granted and exercised in the future.
Note that any increase to the employee option pool post-financing will result in stockholders, including the Investors, being diluted. This is why the Investors (via their Board Seats, if any) would want a right to approve any future option pool increases.