For business owners looking for investors to shore up their business capital and bottom line, careful negotiations are always required to ensure that both parties understand the valuation of said business, both before and after the investor makes their investment. To put it simply, if a large amount of money is sunk into a business, that business is now inherently worth more. Of course, investors don’t tend to give money to a business out of the kindness of their hearts – they’re interested in strengthening it in order to get a beneficial return on their investment.
Believe it or not, there have been many instances where estimated pre-investment and post-investment valuations of a business have not been made clear to both parties before the transaction. It goes without saying that this can cause major legal issues within the new ownership group. Our partner Paul Skeith breaks down how to understand these terms, how to calculate them, and what they mean for both sides.
What Do ‘Pre-Money’ and ‘Post-Money’ Really Mean?
When it comes to pre-money versus post-money valuations, these terms often get confused by business owners and even investors who are new to investing in private businesses. Let’s start first with the pre-money valuation. A pre-money valuation is simply the market value of the business before any new money comes in from an investor. This is how I think most owners perceive the valuation of their business to begin with: what it’s worth right now before the investor money comes in.
Now, let’s take a look at post-money valuation. The simple definition of ‘post-money valuation’ is the market value of the business after that new money comes in. In other words, a business’ post-money valuation is its pre-money valuation plus the investment money that is received. Seems easy enough, right? However, these two different valuations can sometimes lead to serious misunderstandings between business owner and investor. When a potential investor and owner are discussing valuation, it is crucial that both sides are on the same page as to whether they are talking about pre-money or post-money.
Get on the Same Page
Just how critical is this valuation agreement? Suppose that an investor believes that the valuation of your company will be $10 million post-money and is willing to invest $4 million towards that aim. What would the investor think that their percentage of ownership is going to be? If you said 40%, not so fast. The investor is most likely assuming it will be roughly 67%. Why is that? Because $4 million is 67% of $6 million.
And why are we using a figure of $6 million to make this calculation? Remember, post-money valuation is determined by taking the business’ pre-money valuation and adding the investment amount. So, in this instance, saying the business is worth $10 million “post-money” is exactly the same as saying it is worth $6 million “pre-money.”
Now suppose that the investor and the owner both understand and agree upon a company valuation of $10 million PRE-MONEY during the negotiation. In that situation, the investor with a $4 million investment is rightly expecting 40%. Because this was clearly specified during the transaction, there are no unwelcome surprises.
Protect Yourself and Your Business
Most real-world examples are more complicated than the above scenario, but that is the basic gist of how pre-money and post-money valuation works and how disagreements can sometimes arise. As you can see, which particular valuation method is being discussed has a significant impact on ownership percentages. That’s why it’s so important for both owners and investors to be clear up front. That way, both parties know which valuation method is being implemented and both have a solid expectation of what investors are expecting for their investment.
For all large-scale business transactions, it is imperative that issues like this are raised and agreed upon to avoid complicated – and sometimes costly – misunderstandings. And it often helps to have experienced legal counsel to assist during the process. If you’re looking to take on investors to help boost your capital, Richards Rodriguez & Skeith’s business and transactional attorneys may be able to help you. Contact us today to speak with one of our partners.