Valuation Explained, Part 2: How to Value Your Startup (Pre-Revenue)

If you’re trying to raise money for your startup business, but you are pre-revenue (or pre-significant revenue), there are some things you need to know. First, getting a valuation on a early-stage business is closer to an art form than a science. Each investor, venture capitalist, or even bank will look at different factors to determine what they can offer. However, there are some guidelines that can be used to help give you a general idea of what you can expect.

Pre-Money vs Post-Money Valuation; Dilution

The first thing to understand are the general terms used when negotiating with a potential investor. The two most important examples are pre-money and post-money valuation. Pre-money valuation is how much the company is worth before you get any investments. The post-money valuation is how much the company is worth after an investor puts money into it. For example, if your business is worth $3,000,000 and an investor puts in another $1,000,000, your pre-money valuation is $3,000,000 and your post-money valuation is $4,000,000.  In our example the investors would be purchasing approximately 25% of the company (i.e., investment/post-money valuation). This last step is critical to understand the dilutive effect of the investment. In our example, the owners of the company (pre-transaction) will be diluted by 25%.  Entrepreneurs should give thought to the valuation and the dilutive effect of the contemplated offering, as, after a few rounds of financing, the entrepreneur may shift from being a majority shareholder (and controlling party) to a minority shareholder (without the ability to control).

Recognize the Risks

When you are running a business, you are really able to see the potential for success. For many business owners, however, it is difficult to see that investors are really going to break this down into a risk vs. reward calculation. For pre-revenue startups, there is always going to be very significant risk involved for the investors. As a result, an investor will typically make their offer based on the goal off a significant return on their money. Often, given the higher levels of risk involved, it’s just a practical reality that you need to accept when valuing this type of business. Of course, there are exceptions to this rule, so don’t accept a bad investment deal just because it is widely seen as “standard.”

Take All Terms Into Account

When bringing on investors at this stage of a business, the main things to look at are your initial valuation, and either the interest rate, the percentage of ownership, or other ways the investor will get money back. There are, however, plenty of other things you can offer a venture capitalist or other investor to make the deal more attractive. Consider offering preferred dividends, better stock deals, better rates for future rounds of funding, or any number of other things.

Work with an Attorney

Any time you are looking to raise capital for your business, you will want to have an attorney at your side to help you through the process. This type of deal can be a complex legal matter, and one where even small mistakes can be very costly. Contact Doida Law Group to schedule a consultation so you can sit down with us and discuss your options.

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