In quite simple words, valuation is the monetary value of the company. More often than not, internally, all company shareholders agree on a formula or arrangement to determine valuation in the event of a partner’s demise or exit, which is also ideally documented and captured in all relevant agreements and communications within the firm, whether partnership, private limited, or public companies. When looking for venture or angel financing, the valuation is, honestly, whatever the entrepreneur can convince investors to agree on.
The difference between pre-money valuation and post-money valuation is also very simple. Pre-money refers to the company’s value before receiving funding. These terms are important because they determine the equity stake the entrepreneur will give up during the funding round.
Post-money valuation = pre-money valuation + new funding
Let us understand this with an example. Say a venture firm agrees to a pre-money valuation of $10 million for the company. If they decide to invest $5 million, that makes the company’s post-money valuation $15 million. Here, the investor’s $5 million stake means they are left with 33% ownership of the company ($5 million/$15 million).
Let's consider a counterexample. Say the company was valued at $10 million post-money instead, implying a $5 million pre-money valuation. This means that the investor’s $5 million counts as half the company’s valuation. The investor comes away with 50% of the company in this scenario, rather than 33%. Given the difference in equity, one can see how important it is to have a clarity on pre- and post-money valuations when discussing investment terms.
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