If you are considering raising money to set your company up to achieve its business plan and grow, one of the very first things to consider is the value of your company both before and after that capital raise. But first you need to understand that the valuation process is quite challenging, and in many instances, the valuation can be a very subjective exercise. If you believe you do know the value of your company prior to raising capital (commonly referred to as the pre-money valuation), what will the value be after receiving the cash infusion (the post-money valuation)? Is the calculation a simple equation in which the amount invested divided by the percent received yields the total value for the company? The answer is, it depends.
If your company raised cash through venture capital (VC) or private equity (PE), a simple or back-of-the-envelope calculation is not appropriate. That’s because most VC- and PE-backed companies have multiple classes of equity, with each class having certain rights and preferences. An equity class that receives benefits over and above another equity class tends to be worth more.
As the name implies, a pre-money valuation is the equity value of a company before it receives any cash through a capital raise or stock offering.
A post-money valuation is the company’s equity value after receiving an investment from a recent round of financing. For most equity investments, the purchase price for the stock is determined by taking the total pre-money equity value and dividing it by the fully diluted shares outstanding. For example, if your company’s pre-money value is $20 million and it has 1 million fully diluted shares, then the price per share is $20 and your company would likely sell shares at that price. Now, let’s assume your business needs to raise $5 million to fund operations. The post-money impact of this pre-money valuation would be that your company issues 250,000 shares of stock ($5.0 million divided by $20 per share equals 250,000 shares), which represents 20 percent of the company post-close.
Using this example, many would argue that your company’s post-money valuation is $25 million. But is that valuation correct?
How Share Type Affects Valuation
As mentioned earlier, for many VC- and PE-backed companies, a simple post-money valuation is not appropriate. To start with, determining the value of a privately held company can be subjective because the founders often have a very optimistic outlook about their company. VC and PE firms will typically require preferred shares as a mechanism to help bridge that gap between subjective value and market reality.
Similar to common stock, preferred stock confers equity ownership in a company. Shareholders of preferred stock, however, have priority on dividends and earnings and are at the top of the equity stack at time of liquidation.
Additionally, depending on the terms negotiated, preferred stock can convert and participate as common stock. These conversion and participation features could have a significant impact on the proceeds available to common stockholders.
As a result, these differing equity classes can have substantially different per-share values, depending on their rights and features. If you assumed that all common shares are worth the same as the preferred shares issued in a recent round of financing, your result would be a substantial overvaluation of the company.
Each time your company raises capital, a new series of preferred stock is issued to investors. Preferred shares issued by private companies are not always the same as preferred shares issued by companies listed on public exchanges. Specifically, preferred stock often has liquidation preferences. Liquidation preferences determine the order in which proceeds will be distributed to various equity classes upon a liquidity event such as dissolution, initial public offering, sale, or merger. Preferred shareholders usually receive proceeds before common shareholders receive proceeds.
Another feature is that preferred shareholders often have an option to convert their shares into common stock. This allows them to benefit from increases in the equity value. The conversion rate is based on the terms negotiated and is not always one to one. Preferred shareholders could achieve a significant return on their investment by converting to a much higher number of common shares. The conversion ratio may even be adjusted from time to time to prevent dilution of ownership due to subsequent financing rounds.
These liquidation preferences and conversion features, along with other rights, can make a series of preferred stock significantly more valuable than common stock. Accordingly, it would be inappropriate to just gross up the value of cash received from the recent equity raise by the diluted ownership interest.
Is There a Better Post-Money Valuation Approach?
Before entering into an agreement to raise capital and sell preferred shares in your company, you need an understanding of different types of equity and their contractual rights and features. Once you understand the fundamental concepts, you should be able to analyze the payoff structure and conversion points and derive what the payoff structure might look like at different values.
If we consider an example where a company has not appreciated in value after raising capital, we can see how detrimental this equity raise is for the common shareholders. If we assume that the firm providing the $5 million preferred investment from our example above was entitled to receive dividends at an annual rate of 10 percent ($500,000) upon a liquidity event but did not have the ability to convert its shares to and participate as common stock, the below table illustrates how proceeds would be shared by each equity class five years from the date of that investment.
|Exit at Post-Money Value of $25 Million||$17.5 million||$7.5 million|
|Exit at $20 Million Value||$12.5 million||$7.5 million|
|Exit at $10 Million Value||$2.5 million||$7.5 million|
|Exit at $5 Million Value||$0||$5.0 million|
This table illustrates why it is so important to understand the behavior of different equity classes and their features. The difference in proceeds to each equity class could be even greater to the extent the preferred shares had additional features such as the ability to convert and participate as common stock.
As illustrated above, if an exit event is not imminent, a simple waterfall approach of subtracting the preferred liquidation preference from the total equity value (current value method) will not accurately value the junior securities, such as common stock. After you receive an investment and sell preferred shares, it may be several years before your company is sold. This could benefit the common shareholders if your company’s performance and value increase.
A number of white papers and accounting standards offer guidance on best practices when determining the value of a company after an equity raise. Some of the methods they suggest are complex, but these sophisticated models do help founders better understand their potential risk from an investment by a VC or PE firm. The figures in the table above illustrate the potential impact equity financing can have on common shareholders.
The Bottom Line
There is no “one size fits all” method when determining a post-money valuation and allocating equity value to various equity classes. The right methodology (and its complexity) depends on your company’s stage of development and its capital structure. An independent valuation firm can be of benefit by assisting business owners, finance executives, and VC or PE firms alike with complex valuation issues resulting from an equity raise. Moreover, an independent valuation firm can assist with compliance and regulatory issues that often arise after an equity raise.