Pre-money valuation guide for startup founders‍

How to calculate pre-money valuation

A company's equity value is listed on the balance sheet as “shareholder equity.” That number can also serve as the company's pre-money valuation. The balance sheet subtracts liabilities from assets to calculate this value, so you may also hear it referred to as book value. However, this should not be taken at face value; the line items on the balance sheet play a role in this calculation.

One example of a potential discrepancy in the balance sheet is intangible assets like copyrights, patents, and intellectual property. Their worth is estimated by projecting what those assets will generate in future cash flow. Unfortunately, potential investors may not agree with those estimations, creating a need for additional valuation methods.

Fair market value (FMV) is another metric that can be used for pre-money valuation, but only if the company has a third party conduct a 409A valuation. FMV can also be influenced by market activity or the value of comparable companies, but venture capitalists prefer something official. The company’s worth must be accurate before executing a Series A or seed round.

Pre-money valuation has nothing to do with individual price per share; those share prices will not change when the round of funding closes. Entrepreneurs' ownership stakes will change due to dilution when new shares are issued, but that doesn’t alter the overall valuation of the company.

Factors influencing pre-money valuation

The value of intangible assets isn’t the only variable affecting pre-money valuation; the company's financial health is also crucial. New investors don’t just look at the balance sheet; they want to see all financial reports, including income and cash flow statements. Those numbers don’t appear on the cap table.

Issuing convertible notes and stock options can create a valuation cap that limits both pre-money and post-money valuations. This could complicate capital raising or launching an IPO. Executing those options to obtain an unencumbered number of shares makes it easier to calculate the true value of the company.

Market conditions also play a significant role; demand for companies in your sector can fluctuate. New technology can render products or services obsolete, or it could increase the value of an early-stage startup if utilized effectively within your industry or if you own relevant patents. Angel investors often look for such scenarios when evaluating potential investments.

Analyzing projected cash flows can also assist in calculating pre-money valuation. The discounted cash flow (DCF) method determines how much money an investor can expect to make on a company over time by measuring future cash flow using a discounted rate applied to present value. This technique is common when calculating fair market value.

Lastly, consider the quality of your team. Investors will closely examine their track record, so enhancing your board with prominent figures could improve your standing with venture capital firms and equity investors.

Impact on ownership structure

The pre-money valuation doesn’t affect ownership structure because it’s based on existing assets and liabilities before any new investment amount is offered in a fundraising round. However, it does impact existing shareholders by setting their share price. New capital exchanged for equity will dilute share values.

Pre-money valuation serves as a baseline metric that can be calculated pre-revenue and recalculated each financial reporting cycle. Owners can use it as a metric to evaluate growth or as a starting point to raise funds. Ownership percentages won’t change unless new common shares are issued. Many startups opt for preferred stock in equity financing deals.

A higher valuation increases equity value for owners and shareholders. For instance, ten thousand shares of common stock are worth $200 each if the pre-money valuation is $2 million. If that valuation increases to $2.5 million, shares are worth $250 each. A primary owner with 60% of the company’s stock holds $1.5 million of that equity value.

Issuing new shares of common stock in a fundraising round will dilute ownership percentages. If five thousand new shares at $250 each are exchanged for $1.25 million in new capital, total common shares increase to fifteen thousand. The primary owner still controls 6,000 shares, but their ownership percentage drops to 40% after equity dilution.

Tips for founders negotiating pre-money valuation

To gain an accurate picture of your company's worth, utilize multiple valuation methods:

• Review your balance sheet for a baseline.
• Weigh that against fair market value and comparable values from other companies.
• Use discounted cash flow analysis to estimate potential returns over time.

Hiring a third party for a 409A valuation is necessary if your company plans to go public; however, this should ideally be done before launching any fundraising round. Be cautious—if you don't increase assets and reduce liabilities first, this may impact valuation outcomes. Adding influential figures to your board or executive team may help support credibility during negotiations.

Founders should view pre-money valuation as merely a starting point—a metric for financial planning and growth evaluation over time. Regularly tracking financial cycles may help demonstrate growth to current shareholders and attract potential investors who can help scale your business. Be mindful not to promote valuations lower than market expectations; doing so could hinder financing opportunities. Focus on improving financial metrics—cut expenses and increase revenue—before recalculating your valuation.

Wrap-up

A strong pre-money valuation may enhance individual share values, potentially providing more equity available during fundraising rounds with less dilution for existing shareholders. Offering preferred stock in financing deals may affect valuations without diluting common stock voting privileges or ownership percentages.

The pre-money valuation can serve as a baseline for financial analysis and planning while helping establish targets for post-money valuations during fundraising rounds. Higher pre-money values may provide opportunities for achieving elevated post-money valuations.