There is a widely held belief in the venture capital world that needs a bit of debunking. The myth regards "pre-money valuation."
First, let me review the venture capital definition of pre-money valuation: the value of the enterprise before the investment. Hence, if the investment is $4 million and the investor received shares equal to 40% of the fully diluted shares of the company, the business is said to have had a $6 million pre-money valuation.
Mathematically, this makes perfect sense. Here, however, are the flaws in the logic:
The venture capitalist will, traditionally, receive preferred shares with a host of rights that common shares held by founders don't have with the net result that common shares are worth much less than the preferred.- Options, counted in the "pre-money valuation," are subject to a variety of factors that make them worth much less than common stock
- Many of the shares used to calculate pre-money valuation aren't even outstanding at the time of the VC's investment--and may never be!
So let's consider our mathematical example above. The venture capitalist receives preferred shares that entitle her fund to receive the first $4 million in a liquidation, hence, those shares are worth at least what was paid for them.
The pre-money value is associated with a combination of common shares and options typically held by founders, angel investors and employees. In addition, a reserve pool of options for future grants are also included.
The pre-money portion of value is associated with claims that are secondary to the preferred shares, have fewer corporate governance rights and are customarily subject to other agreements with the investors that limit voting and transfer rights.
Venture capitalists are well aware of this dichotomy. The IRS now appears ready to require third-party valuations of common stock prior to granting options. VCs have traditionally used a ratio of ten percent to estimate the value of common stock in an early stage deal relative to the value of the preferred stock. Third-party valuations fall roughly in line with this tradition.
So, in our example, the VC might have paid a dollar per share for 4 million shares, but the six million common shares are really only worth $0.10 each or $600,000. But wait! Half of those shares are in the form of options that require the purchase of the shares for $0.10. An option on a share worth $0.10 with a strike price of $0.10 is worth only a few cents, let's say $0.03 per share. Finally, half of the options haven't been granted, yet.
So in our example, we have 3 million common shares worth $300,000, 1.5 million options worth a total of $45,000 and a reserve of 1.5 million options not granted and that therefore have no value at the time of the VC funding. So, the pre-money value of this company may be as little as $345,000.
Frankly, the value of these shares at the time of the venture investment is not very important. The important question is the value of the shares and options at exit! In a typical VC deal, the VC will be required to convert to common in a successful exit, with the result that the value per share for the VC's shares and the founder's share will be the same. So all's fair!
If your business can't succeed without venture capital, don't sweat the terms. Sweat growing your business to succeed. If your business doesn't need venture capital, give some consideration to whether or not you really want it!
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