I’m thrilled to introduce a guest blogger today. Michael Sinsheimer is a serial entrepreneur and angel investor specializing in med tech. (See “MedTech Catalyst“) This guy knows what he’s doing, so I’ll let him explain valuation. Here’s Mike:
When an entrepreneur sells stock in his company, he’s got to come up with a price. This is called the “valuation” and it reflects the value of the business resources, the operations, and in most cases, the value of the future.
There are two ways to talk about valuation — Pre-money and Post-money. In other words, how much value does the company have before the investor’s dollars, and then what is the total value after the investor has put his money in?
Pre-money valuation – is the current negotiated value prior to a new investment being made into the company.
Post-money valuation – is the valuation after an investment is received and is based on the pre-money valuation plus whatever dollar investment is received in the current round.
This is easy to see in a simple example:
- Say that an investor will put in $1 million, and that the stockholders have agreed to sell 10% of the company for that investment. You can see that if 10% = $1 million, then 100% = $10 million. Easy enough. But that’s the valuation AFTER the money is invested, or “post-money valuation”
- The “pre-money valuation” of the company is just $9 million ($10 million – $1 million).
- The capitalization table, or cap table, will show that the new investors receive 10% of the company ($1M/$10M) and the existing stockholders retain 90% of their holdings.
- Putting this into a cap table format will also show that old stockholders have been diluted by 10% by the new investment… meaning they each own 10% less of the company than they did before the investment.
This may seem pretty straight forward, but things can get a little messy. For example, something really interesting occurs if the full amount is not invested.
Using the example above, if the full $1 million is not sold, the post-money valuation of the Company decreases. An interesting result that comes out in the calculation — Since not as many dollars were invested, the new investors actually receive a greater percentage of the Company per dollar invested.
- For example: If just $500K is invested instead of $1M, then the post-money valuation is $9.5M instead of the $10M.
- Since the total is less, new investors have received a larger percentage of the total. In this case, the new investor owns 5.3% of the Company – they received more ownership per dollar than they would have if the full investment was received.
- Looking even deeper — and this is confusing to most people — the existing stockholders have been diluted at a rate that is greater per dollar of investment, than would have been the case if the round had maxed out.
- To compensate for this, some entrepreneurs will adjust the price per share.
These are some pretty advanced topics, but if you are headed into even a small round of financing, its crucial that you master these concepts… or have a lawyer or advisor who can.
Good luck with your investment!
Mike is passionate about striving to improve the healthcare system and patient care through the development and commercialization of compelling technology. And he gives back to the community through service on several non-profit boards. Reach Michael through his websites: www.medtechcatalyst.com and www.medsharex.com