Entrepreneurs often start companies that they know will need more capital than they can provide personally. So they at some point go looking for investors, and these days there are lots of individuals and investment funds willing to listen and consider buying a partial interest in the new company. The question then is how much (money) for how much (company). Not surprisingly the buyer and the seller have different opinions on this rather key point, driven by their respective views about valuation. A simple example will make the respective thinking clear.
The entrepreneur’s valuation arithmetic:
|Value of the venture before the investment of $2.5 million (assume this is the entrepreneur’s “pre- money” valuation)||$5 million|
|Value of the venture after the investment of $2.5 million (pre-money valuation + $2.5 million||$7.5 million|
|Value of the investor’s $2.5M in terms of ownership percentage ($2.5M/$7.5M)||33-1/3%|
|Percent of the venture the entrepreneur offers to sell for $2.5M||33-1/3%|
The potential investor’s valuation arithmetic:
|Value of the venture before the investment of $2.5M (the investor sees the business as needing the investment to be truly worth $5M, thus the investor’s pre-money valuation is substantially lower)||$2.5 million|
|Value of the venture after the investment of $2.5M (pre-money valuation + $2.5M = post-money valuation||$5 million|
|Value of the investor’s $2.5M in terms of ownership percentage ($2.5M/$5M)||50%|
|Percent of the venture the investor wants to own for $2.5M||50%|
The difference between the two views is one of perspective. Since both are estimating future value in their negotiation, neither is right and neither is wrong. The stronger negotiating position, based in large part on the market position and potential of the business model, will ultimately determine the final valuation on which the “how much for how much” will be calculated.
The example comes from p.228 of my book, Finance for Nonfinancial Managers, Second Edition, McGraw-Hill Education, 2015. If you want to understand more about this valuation dance, call us at 888.788.6534.