Pre-Money Valuation

How pre-money valuation works

Pre-money valuation is one half of a two-number pair, and it is the half from which the mechanics run.

Written in words, the price per share equals the pre-money valuation divided by the fully diluted share count immediately before the round; the post-money valuation equals the pre-money valuation plus the amount raised; and the new investors' ownership equals the amount raised divided by that post-money valuation.

Price per share = Pre-money valuation / Fully diluted pre-money shares

Post-money valuation = Pre-money valuation + Amount raised

Investor ownership % = Amount raised / Post-money valuation

To back-solve a pre-money valuation from a target ownership, invert the last two lines:

Pre-money valuation = (Amount raised / Target ownership %) - Amount raised

The NVCA model term sheet names the resulting price the Original Purchase Price and states that it is determined on the basis of a fully diluted pre-money valuation. The same clause specifies that the pre-money valuation includes an unallocated and uncommitted employee option pool representing a stated percentage of the fully diluted post-money capitalization. Those two facts, taken together, are the whole of the option pool question: the pool is sized against the post-money but funded out of the pre-money.

What goes in the denominator

Fully diluted is a defined term in practice, not a universal one. Depending on the document it may include or exclude:

• Outstanding common stock. Always included.
• Outstanding preferred, counted on an as-converted basis. Always included.
• Granted but unexercised options. Normally included.
• The unallocated pool remaining in an existing plan. Normally included.
• The newly created or increased pool. Included under the NVCA convention, which is what makes it dilutive to pre-round holders.
• Warrants. Usually included on an as-exercised basis.
• SAFEs and notes converting in the round. Negotiated. Y Combinator's Post-Money Safe User Guide describes the case where parties agree the pre-money will not include converting safes, and notes that the new investors then receive slightly less than the headline percentage and the effective post-money valuation is greater than the stated number.

Pre-money as the anti-dilution baseline

The pre-money valuation of a round also sets the conversion price that anti-dilution protection defends. The NVCA model term sheet provides that if the company issues additional securities at a purchase price less than the current conversion price, that conversion price is adjusted by the formula

CP2 = CP1 x (A + B) / (A + C)

where CP1 is the conversion price in effect immediately before the new issue, CP2 the price immediately after, A the number of common shares deemed outstanding immediately prior on a fully diluted basis, B the aggregate consideration received for the new issue divided by CP1, and C the number of shares actually issued in the transaction. The model form lists customary exceptions, including shares and options issued to employees, directors and consultants under a board-approved plan.

Worked example

Suppose Series A priced at a $3.00 conversion price, with $12,000,000 raised, and the company later does a down round.

Immediately before the down round, A, the fully diluted shares deemed outstanding, is 20,000,000. The company issues 10,000,000 new shares at $1.00 for $10,000,000.

B is the aggregate consideration divided by CP1: $10,000,000 divided by $3.00, or 3,333,333.

C is the shares actually issued: 10,000,000.

CP2 = $3.00 x (20,000,000 + 3,333,333) / (20,000,000 + 10,000,000)

CP2 = $3.00 x 23,333,333 / 30,000,000 = $2.3333

The Series A conversion price falls from $3.00 to $2.3333. The Series A investors bought 4,000,000 shares for $12,000,000; on conversion they now receive $12,000,000 divided by $2.3333, or 5,142,857 common shares instead of 4,000,000. The extra 1,142,857 shares come out of everyone who is not protected, which is the founders and the employees.

Compare that with full ratchet, the harsher alternative, under which the conversion price would simply drop to the new issue price of $1.00. The Series A would then convert into $12,000,000 divided by $1.00, or 12,000,000 shares, three times their original count. The difference between broad-based weighted average and full ratchet, on the same facts, is nearly 7,000,000 shares of founder and employee dilution. All figures are hypothetical.

Where it shows up

In the term sheet, pre-money appears under a heading the NVCA model form labels Pre-Money Valuation, in the offering terms block above the charter provisions. The clause states the price per share, defines it as the Original Purchase Price, names the fully diluted pre-money valuation, specifies the option pool percentage, and names the fully diluted post-money valuation in the same sentence.

In the stock purchase agreement, the pre-money valuation itself usually does not appear. What appears is the price per share it produced, the number of shares being sold, and a capitalization schedule showing the cap table immediately before and immediately after closing. A dispute about pre-money valuation almost always turns into a dispute about the capitalization schedule.

In the certificate of incorporation, the number that survives is the conversion price, which starts at the Original Purchase Price and is adjusted under the anti-dilution article using the formula in the model term sheet.

In a safe, the analogous field is the valuation cap. Y Combinator's original safe used a pre-money cap; the post-money safe replaced it with a Post-Money Valuation Cap, and the user guide explains the change was made so that the ownership sold is immediately transparent and calculable, since it equals the investment amount divided by the cap.

In a fund's quarterly report to limited partners, the pre-money and post-money valuations of the latest round appear as the market evidence supporting a private holding's fair value mark. The Institutional Limited Partners Association's reporting template standardises the fund-level capital account statement around them, the movement from beginning to ending net asset value with its cash flows, fees and accrued carried interest, rather than the way any single holding's round valuation is presented.

Common mistakes

• Comparing term sheets on pre-money alone. The pool percentage, the treatment of converting instruments, and the fully diluted definition all move founder ownership at a constant pre-money. Compare post-round percentages instead.
• Accepting a large pool without a hiring plan. Under the NVCA convention, every point of pool inside the pre-money is a point taken from existing holders. Sizing it against an actual twelve to eighteen month plan is the negotiation.
• Maximising pre-money without regard to the next round. The pre-money valuation becomes the conversion price that anti-dilution defends, and a price the company cannot grow into triggers the adjustment formula against the founders.
• Assuming full ratchet is off the table. It is a drafting alternative, and the gap between it and broad-based weighted average is large enough to dominate every other term in a down round.
• Forgetting warrants and unallocated options in the denominator. Both reduce the price per share, and both are easy to leave out of a quick model.
• Confusing the safe valuation cap with a pre-money valuation. The post-money safe's cap is explicitly a post-money figure, and the user guide states it is post all safe money but not post the equity financing money.

Related terms

Pre-money valuation is the counterpart of post-money-valuation and the input to price per share on a cap-table. It is negotiated in the term-sheet, defended afterwards by anti-dilution, and put under pressure by a down-round. Sizing decisions around it flow into the option-pool and into the dilution founders carry through series-a and later rounds. A safe defers the pre-money decision entirely by using a cap instead.

Frequently asked questions

What is the pre-money valuation formula?

Pre-money valuation equals the post-money valuation minus the amount raised. Working the other way, to hit a target ownership percentage, divide the amount raised by that target percentage and subtract the amount raised. The price per share that follows is the pre-money valuation divided by the fully diluted share count immediately before the round.

What is the difference between pre-money and post-money valuation?

Only when the value is measured. Y Combinator's Post-Money Safe User Guide states it directly: pre-money is the valuation of the company immediately before it receives the investment, post-money is the valuation immediately after. The difference between the two figures equals the amount being raised, so a company raising $2,000,000 at a $10,000,000 pre-money is the same as one raising $2,000,000 at a $12,000,000 post-money.

How does the option pool affect pre-money valuation?

Under the NVCA model term sheet convention, a new or increased employee option pool is created inside the pre-money valuation while being sized as a percentage of the post-money capitalization. That raises the fully diluted pre-money share count, lowers the price per share, and dilutes existing holders only. The investors' percentage is unchanged, which is why a larger pool is economically a lower offer.

Is a higher pre-money valuation always better for founders?

No. A higher pre-money reduces dilution at this round, but it also sets a higher conversion price for anti-dilution purposes, and raises the bar the company has to clear at the next round. It also has to be compared against the pool size and the fully diluted definition, since a higher pre-money paired with a larger pool can leave founders with less than a lower pre-money would.

Do SAFEs count in the pre-money valuation?

It depends on what the parties agree. Y Combinator's Post-Money Safe User Guide describes the negotiated case where the pre-money is agreed not to include converting safes, and explains the consequence: the new investors get slightly less ownership than the headline arithmetic implies, and the effective post-money valuation ends up higher than the stated number. The NVCA model term sheet's amount raised line separately contemplates including converted SAFE and note amounts in the reported round size.

What happens to the pre-money valuation in a down round?

The new round prices below the previous conversion price, which triggers anti-dilution. Under the NVCA model term sheet's broad-based weighted average formula, the earlier round's conversion price is reduced in proportion to how much stock was issued at the lower price, so earlier investors convert into more shares and the unprotected holders, founders and employees, absorb the difference.