When an investor proposes to back your company, they may make a statement such as “I’ll invest $100,000 at a valuation of $1 million”. The thing here to remember is that the price of equity is linked to the valuation of the company. The higher the valuation, the more expensive the shares in that company.
There is a trick though. The question is, does the investor mean your company is valued at $1 million, before or after, they have given you the cash. Or in other words, pre-money or post-money.
Allow me to explain. If the investor says that your company is worth $1 million today, before they give you the investment, then there portion is added to the total value of the company. The math then would be $1 million plus $100,000 for a new valuation of $1.1 million. In other words, the $1 million was the valuation before the investment. That’s pre-money.
Alternatively, the investor could have meant that your company would only be worth $1 million once they have invested in you. So a post-money valuation of $1 million, but actually a pre-money valuation of $900,000.
The main difference here is in the amount of equity the VC gets. As you can see in the chart, if they mean post-money valuation, then their chunk of equity is 10% instead of 9%, which is 1% percent bigger than if they mean pre-money.
This is not a huge issue and is easily clarified by responding to their initial proposal with a statement such as “I assume you mean $1 million pre-money”. The bonus effect is that you come off as more professional and will garner more respect in your negotiations.
To note, this post was inspired by the section on the subject in Venture Deals by Brad Feld and Jason Mendelson.