Term Sheet Basics – Pre-money Valuation

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Term Sheet Basics – Pre-money Valuation

“Pre-money” or “pre-money valuation” is a term that entrepreneurs will hear and use a lot in the context of securing equity financing, so I thought it would be a good idea to make sure entrepreneurs have a clear understanding of it.

A start-up company’s pre-money valuation is essentially the company’s deemed value prior to a preferred stock financing.  It usually appears on the first page of a term sheet, and it is calculated by multiplying (1) the price per share in the company’s current preferred stock financing by (2) the company’s fully-diluted capital ((A company’s fully-diluted capital is just the sum of the number of shares of the company’s common stock that is:  (a) outstanding, (b) issuable pursuant to outstanding convertible securities (like preferred stock), (c) issuable pursuant to exercisable securities (like options and warrants) and (d) otherwise reserved for issuance pursuant to the company’s option plan(s).)) immediately prior to the financing.

By way of example, let’s say a young company is about to conduct a Series A financing at a sale price of $0.50 per share of Series A Preferred Stock and that its pre-financing fully-diluted capitalization is as follows:

Common Stock Outstanding – held by founders:

4,000,000

Option Pool – shares issuable pursuant to outstanding options plus other shares reserved for issuance under the company’s option plan(s):

2,000,000

Pre-financing Fully-Diluted Capital:

6,000,000

In this case, the company’s pre-money valuation is:  $0.50 X 6,000,000 = $3,000,000.

If the company sold 4,000,000 shares of Series A Preferred Stock, then it will have raised:  4,000,000 X $0.50 = $2,000,000.  The company’s post-financing fully-diluted capitalization would be as follows:

Common Stock Outstanding – held by founders:

4,000,000

Option Pool – shares issuable pursuant to outstanding options plus other shares reserved for issuance under the company’s option plan(s):

2,000,000

Series A Preferred Stock Outstanding:

4,000,000

Post-financing Fully-Diluted Capital:

10,000,000

The company’s “post-money valuation” is calculated by multiplying (1) the price per share in the company’s current preferred stock financing by (2) the company’s fully-diluted capital immediately following the financing:  $0.50 X 10,000,000 = $5,000,000.  You can also calculate the post-money valuation by adding the pre-money valuation plus the amount raised in the financing:  $3,000,000 + $2,000,000 = $5,000,000.

It is important to note that the pre-money does not imply that the company’s common stock is suddenly worth the same as the preferred stock.  Common stock is generally worth less than preferred stock, since common stock does not generally have the preferences with respect to dividends, liquidation, voting and other matters that preferred stock generally has.  On a related note, neither is the pre-money valuation the amount that would be received by the holders of the fully-diluted capital immediately prior to the financing if the company were sold for an amount equal to the post-financing valuation.  But we can discuss that in a future post.