VC Math 101
The two most fundamental terms in a venture capital term sheet are the pre-money valuation and the investment size. Adding those two gives you the post-money valuation:
For example, VCs have offered to invest $4M on a $6M pre-money, sometimes called a “4 on 6” deal, though it is becoming more common to hear this as a “4 on 10 post,” as the post-money would then be $10M.
The next level of this algebra is used to determine the ownership structure, and needs to become second nature to a VC. Pre-money divided by post gives you founders’ percent ownership. The investment divided by post gives you the VCs’ stake.
In our 4 on 6 example, we end up with:
Another quick example, let’s say a VC firm is investing $2M in a startup with a pre-money valuation of $3M (or 2 on 3). The post-money valuation is $5M and the VC owns 40%, the founders 60%.
|$2M Investment||+||$3M Pre-Money||=||$5M Post-Money|
I want to take a quick aside to address what I call Shark Math. Due to the popularity of ABC’s show Shark Tank, many people think that equity deals should be offered as “_% of the company for $__.”
As we’ve already discussed, this is not how VCs offer deals because it implies that a percentage of a pre-existing company is being sold (p. 57). With VC investing, a new class of preferred stock is being created and new shares are being sold. Nonetheless, the algebra is the same. Money comes into the startup, and the investors now own a percentage of the company.
If a deal is offered as _% of the company for sale for $__, we can solve for the valuation:
For example, let’s look at a deal where 25% of the company is being offered for a $100,000 investment. Plug that into our deal algebra:
25% VC Ownership
If you are a regular viewer of Shark Tank, you have heard sharks say something like, “Do you realize you are valuing your company at $400,000.” This is actually a manipulation (or a mistake). Take a moment and see if you can catch what the Sharks are trying to do in the above example by claiming the founders are pricing their startup at $400,000.
What is the mistake? (answer below)
Also covered in this chapter in the book:
- Breaking it Down
- Seed Round
- Series A
- Series B
- Series C
- Fund Fit Alert!
- To the Exit
- Back to the Forest: Rules of Thumb
- Adding the Option Pool
The founders are actually pricing their startup at $300,000 prior to receiving the investment. The $400,000 valuation derived in the formula above is post-money. That valuation includes the investment, which the startup has not yet received. The current valuation should be pre-money, and should be $300,000. The valuation will increase to $400,000 after the cash is received.
In manipulating the math, the Sharks are employing a negotiation technique to make the valuation seem higher. Coming up with a valuation, also known as “pricing the deal,” is often the stickiest part of the negotiation. I believe that is why I’m hearing more VCs talk about 4 on 10 post deals, when they used to all say 4 on 6 ($4M investment on a $6M pre-money).
The use of post-money vs. pre-money as the valuation can make a big difference in perception if the investment is for a large percentage of the company. If you take a traditional 2 on 2 deal: a $2M investment on a $2M pre-money valuation, and reframe it as a 2 on 4 post—wow, we just doubled the value of the company!