Equity investors determine the pre-money valuation for a company by setting a fixed price per company share of their investment, and by other investment terms.
In its simplest form, the pre-money valuation translates into what investors think the company is worth before they put in their money. The post-money valuation is then the simple sum of the pre-money valuation and the total amount invested.
For example, if two founders together own 1 million shares, and angel investors are willing to put in $500,000 at a price of $2 per share, the pre-money valuation of the company is $2 million (1 million shares X $2 per share). After the investment, the post-money valuation is $2.5 million.
It’s important for companies to know that pre-money valuation is usually not this simple. One complexity: very often investors will tell young companies that they need to set aside a stock option pool for future employees. For example, the investors’ term sheet with a $2 million pre-money valuation might also specify that an option pool for future employees should be 10% of all shares after the investment. That option pool of unissued shares is used to calculate the pre-money valuation, which ends up reducing the value investors place on founders’ shares.
On the other hand, pre-money valuation can be misunderstood as the single most important item on a term sheet. Some entrepreneurs like to brag about the high valuation of their most recent financing. Sometimes a high valuation comes with tough other terms, such as a high participating preferred liquidation preference, which comes back to haunt bragging founders when their company is sold for a relatively low price.
External resource: Seedcamp’s “Model Equity Calculator for Founders with Option Pool Expansion“