How much is your company worth? It’s often the most important, most contentious (and often the most subjective) question in any negotiation between entrepreneurs and investors.
At the seed stage, any attempt at valuation is highly speculative. Most companies have little or no revenue, a very early version of their product, only a tiny user base, and a small team. Both the entrepreneur and the investor generally try to build a financial model to justify the value of the company. Typically, those models are based on so many speculative assumptions as to render them practically useless in the real world. So, valuations are often based on non-financial factors such as:
- the valuations of comparable companies that have raised recently,
- founder experience,
- macroeconomic conditions,
- what sectors investors find sexy at the moment and,
- investors’ fear of missing out (FOMO).
All of these factors can swing seed stage valuations wildly. Whatever that valuation number is, it’s important for every entrepreneur to understand how the math impacts the ownership of the company.
There are two ways to express the value of a company: pre-money valuation or post-money valuation. Pre-money valuation is the valuation of the startup right before the round of financing, and post-money valuation is the valuation of the startup immediately after the round of financing.
Post-money = Pre-money + Investment
Pre-money = Post-money – Investment
Investor Percentage = Investment / Post-money
For example, say a startup is raising $1 million at a $10 million pre-money valuation.
Post-money: $11 million = $10 million + $1 million
Pre-money: $10 million = $11 million – $1 million
Investor Percentage: 9.09% = $1 million / $11 million
Expressing the valuation of a company in pre-money or post-money terms will impact the amount of equity the investor will receive for their investment. So, if an investor offers to invest $1 million at a $10 million valuation.
The investor usually means post-money.
Post-money: $10 million = $9 million + $1 million
Investor Percentage: 10% = $1 million / $10 million
However, the entrepreneur usually means pre-money.
Pre-money: $11 million = $10 million + $1 million
Investor percentage: 9.09% = $1 million / $11 million
In the post-money calculation, the investor gets a higher percentage of the company. Thus the founders get a lower percentage. Entrepreneurs can avoid a well-intentioned miscommunication (or potentially a sneaky VC trap), by simply asking, “Ten million pre- or post-money?” Remember pre-money is always better.
The Option Pool
In the Series Seed term sheet, there are two parts to the definition of price per share: The valuation is the most important, but the last clause about the option pool is also meaningful.
What is an option pool? The option pool is a set number of shares that are designated exclusively for stock options and grants to employees and advisors of the startup. It is designed to incentivize and attract talent to work for or stay with a startup. Increasing an option pool can help the company compensate and motivate its workforce, but it also dilutes the other shareholders. The general rule is decreasing the size of an option pool increases the valuation of the founder’s percentage of the company (see table below).
|No option pool||5 million|
|25% option pool||3.75 million [5 million* (1-0.25)]|
|20% option pool||4 million [5 million* (1-0.2)]|
|10% option pool||4.5 million [5 million* (1-0.1)]|
Though the standard Series Seed docs list the valuation of the company as a pre-money valuation, it’s important to note that the option pool is expressed as post-money. (A little confusing, I know.) So, when it’s expressed as a percentage, that means a percent of the total number of shares after the funding closes. A founder can counterbalance the negative impact on the value of your stock in two ways:
- Increase the pre-money valuation to account for the value lost from the option pool; or
- Decrease the percentage of the option pool.
Before entering a negotiation, it’s helpful to have a hiring plan and the amount of options you are planning to grant to each hire. This can help entrepreneurs negotiate an appropriate option pool size with the VC. Increasing the option pool size might not be necessary if the company is not planning to increase hiring between current and next anticipated financing date. Similarly, the entrepreneur might want to take into account a larger option pool if there are plans to increase hiring before the next round of financing.
In the Series Seed term sheet, the price per share is as follows:
Price per share: Price per share (the “Original Issue Price”), based on a pre-money valuation of $[____], including an available option pool of [___]%.
Thus, upon negotiation with the investor, the startup will set the pre-money valuation investor along with the option pool.