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Calculating the financial aspects of your company’s capital raise can be challenging. In particular, startups are known for being difficult to value. However, it is crucial that you thoroughly understand the capital raising process. This article highlights the key issues to consider when calculating the economic terms of your capital raise as a startup founder.

Setting the Pre-Money Valuation  

Your company’s pre-money valuation refers to its value immediately before the latest round of any outside investment. Therefore, this valuation is critical in determining how many shares a potential investor will receive for their investment. 

There are several ways you can value your startup when capital raising. Ultimately, both the company and the potential investors must agree on the valuation. In the early stages of your startup, you will base this valuation on intangible considerations such as its growth potential. 

For example, if you agree to give an investor 10% of your company’s equity for $100,000, your startup’s pre-money valuation will be $900,000, and its post-money valuation will be $1 million. Of course, this does not necessarily mean your company would be worth $1 million if you decided to sell it today. 

The pre-money valuation can be a reflection of several factors, including the:  

  • current and projected revenue of the business; 
  • reputation of the business and its business owners – founders with good reputations will attract higher valuations; and
  • analysis of the market in which the business operates and its key competitors – if products or services are in high demand and there is a scarcity of supply or a lack of competition in a particular market, you may attain a higher valuation. 

Deciding Between Undiluted or a Fully-Diluted Basis

Usually, a key negotiation point when raising capital is whether the pre-money valuation will be calculated on an undiluted or fully diluted basis. 

Undiluted capitalisation refers to the number of shares in your company which currently exist and are on issue. 

In contrast, fully diluted capitalisation refers to:

  • the number of current shares on issue; plus 
  • any shares that could be issued in the future if the company’s options and convertible instruments are converted into shares. These could include employee options pools, SAFEs and convertible notes.

Suppose your company has 100,000 shares on issue and an employee options pool under which it has reserved a further 10,000 shares to issue to employees. In this case, the fully diluted share capital of the company is 110,000 shares (shares on issue + shares reserved for future issue). 

Furthermore, incoming investors typically want to invest on a fully diluted basis to protect themselves from risk. This ensures that the founders and existing shareholders will bear any dilution resulting from the issuing of shares in the future.

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Post-Money Valuation

As the name suggests, the post-money valuation is the company’s valuation immediately following an investment round. This is equal to the company’s pre-money valuation plus the amount invested during the financing round. 

Suppose a company is about to undertake its seed investment round and agrees to a pre-money valuation of $15,000,000 with its investors. The company proposes to raise $5,000,000 in the round. Therefore, the company’s post-money valuation is $20,000,000 ($15,000,000 (pre-money valuation) + $5,000,000 (funds invested in the round) = $20,000,000).

Calculating the Share Price 

Once you have agreed on your company’s pre-money valuation and the size of the investment amount, you can then calculate the issue price of the shares. This is the price per share payable by the investor, and determines the number of shares they will receive in exchange for their investment. 

Below is an example of a hypothetical investment round. This illustrates how the share issue price and correspondingly the number of shares to be issued is calculated. 

Example

Suppose:

  • the investor agrees to invest $2,000,000 in the company on a fully-diluted basis;
  • the company has a pre-money valuation of $4,000,000; and
  • there are 2,000,000 shares on issue in the company and an additional 200,000 shares reserved for the company’s employee share option pool. 

You will calculate the issue price as the pre-money valuation / existing shares + shares in the company’s options pool: 

  • 4,000,000 / (2,000,000 + 200,000) = $1.81818

The number of shares that the investor will receive is the investment amount / the share issue price:  

  • $2,000,000 / $1.81818 = 1,100,000

In the above example, we can see that the investor will receive 1,100,000 shares for $1.81818. Following the raise, the company’s fully diluted share capital will be: 

  • investor = 1,100,000 shares 
  • existing shareholders = 2,000,000 shares
  • employee share option pool = 200,000 shares

Key Takeaways

Calculating and agreeing on the pre-money valuation of your startup is critical in determining the share issue price and the number of shares investors will receive. Startup founders may need to rely on intangible factors like market traction and reputation to reach a reasonable pre-money valuation. Once you and your investors agree on the pre-money valuation, you can then determine the share issue price and the number of shares the investor will receive. If you need help with understanding the financial terms of your capital raise, our experienced capital raising lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions

What is my company’s pre-money valuation?

Pre-money valuation refers to your company’s value immediately before a round of outside investment.

What is my company’s post-money valuation?

Post-money valuation refers to your company’s value immediately after an investment round.

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