"Valuation Strategies in Venture Capital: Understanding Pre-money and Post-money Valuations"

Pre-money & Post-money: The VC playbook

In public company valuation, the contrast between pre-money and post-money valuations has almost never been an issue, but in venture capital valuation, it is front and center. It plays a central role in Venture capital investing, and the consequential effects have to bear on both capital providers and capital seekers, assuming that the venture capital playbook includes detailed instructions on the contrast between Pre-money and Post-money valuation. If you pay $X for y% of a business, the post-money value is the resulting scaled-up value, and netting out the cash influx yields the pre-money value:

Post-money value = $X/y%, Pre-money value = $X/y% - $X

One can compare the two offers now in post-money and pre-money terms:

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The two offers effectively attach the same value to the business and at least on this dimension, the entrepreneur should find them equivalent. While the VC definition is technically right, it is sterile, because if one has a Pre-money value for a business, one can always extract the post-money value, or vice versa, but both estimates are only as good as the initial value estimate. It is also opaque because the process by which value is estimated is often unspecified and made more so when the simple exchange of capital for a share of ownership is complicated by add-ons, with options to acquire more of the business, first claims on cash flows and voting rights thrown into the mix.

While some of the opacity that accompanies pre-money and post-money valuations is related to the fact that dealing with young, start-ups, often without operating histories or clear business models. By leaving the discussion of value vague and/or making the exchange of capital for the proportion of the business complicated, venture capitalists can create enough noise around the process to confuse entrepreneurs about the values of their businesses. By the same token, the sloppiness that accompanies much of the discussion of Pre-money and Post-money valuations in venture capital can also lead to excesses during periods of exuberance, where the fact that too much is being paid for a share of a business is obscured by the confusion in the process.

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Pre-money and Post-money in an Intrinsic Value World

The intrinsic valuations (and DCF valuations, a subset) are considered to be unworkable by many in the venture capital community, with the argument given that the young, start-ups that VCs have to value do not lend themselves easily to forecasting cash flows and/or adjusting for risk. Further, the path to understanding pre-money and post-money values is through the intrinsic valuation of a very simple business.

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The Franchise Stage

Let's assume that a person is politically connected and that the government has given a license to build a toll road. The cost of building the road is 100 Cr. and to keep things really simple, let's assume that the government has agreed to pay 10 Cr. a year in perpetuity, living in a tax-free environment and that the long-term government bond rate is 5%. To get a measure of the value of the license, just have to take the present value of the expected cash flows, net of the cost of building the road:

NPV of road = - 100 + 10/.05 = 100

While a conventional accounting balance sheet would show no assets and no value for the business (since the road has not been built), an intrinsic value balance sheet will show this value:

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Note that the 100 Cr. value attributed to you (as the equity investor) in the intrinsic value balance sheet is based on a notional toll road, not one in existence.

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The Capital Seeking Stage

Now, let's assume that a person doesn't have the capital on hand to build the road and approach someone (a venture capitalist) for 100 Cr. in capital that a person plans to use to build the road. Assuming you are convinced of the viability of the business and that invest 100 Cr. in the project, here is what the balance sheet will look like the instant after investment.

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Note that the business value has doubled to 200 Cr., with half of the value coming from the cash infusion. That cash is transitory and will be used by you to invest in the toll road, and the minute that investment is made, the balance sheet will reflect it.

While the value of the business has not changed from the post-cash number, the nature of its assets has, with a physical toll road now setting value, rather than a license and cash. Thus, the value of the business after the cash infusion is 200 Cr. and this is the post-money valuation of the company.

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The Negotiation Stage

The question at this point is what proportion of the business should get as the venture capitalist. At first sight, the answer may seem obvious. The value of the business, after the capital infusion (and investment) is 200 Cr., and the capital VC is providing is 100 Cr., The actual answer will depend upon the bargaining power (as the entrepreneur) and the venture capitalist and the easiest way to see this is in the limiting cases:?

Case 1

Only entrepreneur in the market, lots of capital providers:

Assume that the only entrepreneur with a valuable franchise in the economy and there is a large supply of capital (from banks, venture capitalists, private equity investors). As the entrepreneur, has all the power in this negotiation and will end up with a 50% share of the post-money valuation (200 Cr.).

Case 2

Lots of entrepreneurs with valuable franchises, a monopolist capital provider:

At the other extreme, if the VC is the only game in town for capital, an entrepreneur will argue that without an entrepreneur the franchise is worth nothing and would end up with all of the value (close to 100% of the business).

The reality will fall somewhere in the middle. In general, the value that you will use to compute the percentage ownership will be neither the pre-money nor the post-money value. It will be the value of the business, with the next best capital provider providing 100 Cr. in capital. In the toll road example, assume that a person can borrow 100 Cr. from a bank at 7.5%, a rate that is much too high, given the risk of the investment (zero). The value of the equity in this toll road will now have to reflect the interest payments on this debt.

Cash flows after debt payments = 10 Cr. - .075 (100) = 2.5 Cr.

Value of equity = 2.5 Cr. / .05 = 50 Cr.

The new balance sheet of the business will reflect this expensive debt:

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Note the bank has effectively claimed 50 Cr. of the value of the business by charging too high a rate and netting out the bank's surplus yields a value of 150 Cr. for the toll road, the "ownership value" since the ownership stake will be based on it. As venture capitalists, entrepreneurs recognize that this is the next best option and demand two-thirds of the business for 100 Cr... In summary, the ownership percentage of the business that will get in return for the capital provision can range from 50% to close to 100%, depending on the relative supply of entrepreneurs and venture capital in a market.?

Implications

A DCF valuation always yields a pre-money value for a business.

The value of a business, after a capital infusion, will have to incorporate the cash that comes into the business, pushing up the post-money value.

The "ownership value on which the ownership proportion is negotiated will move towards the post-money value when there is an active and competitive (venture) capital market and towards the pre-money value.

The Pricing World

Pre-money or post-money?

As noted at the start of the last section, most venture capitalists swear off DCF for many reasons, some justified and some not. Instead, they price businesses using a combination of a forecasted metric and a multiple of that metric (given what others are paying for similar businesses right now). Thus, if one is valuing a start-up money-losing technology firm with no revenues today, one would forecast out revenues three years (or five) from now and apply a multiple to those revenues (based on what the market is paying for public companies in this space) in the third year to get an exit value, which one will then proceed to discount back at a "target" rate of return to get a value today:

Pricing: Pre- or post-money?

While valuing the price companies, the question of whether the value arrived at today is a pre-money or post-money valuation becomes murkier. The forecasted revenues that forecast in year 3 are not (and often are) only based on the assumption that there is a capital infusion in the firm today but there may be more capital infusions in the future, in which case it is a post-post-post money valuation and adding cash to this value will be double counting.?

Pre-money pricing?

Modifying the VC approach to deliver pre-money pricing?

Yes, and here is what have to do. We have to forecast two measures of future earnings, one with the capital infusion and one without. In the extreme scenario where the start-up will cease to exist without the capital and there are no other capital providers, the expected earnings in year 3 will be zero, yielding a pre-money valuation of zero for the company. Consequently, will demand all or almost all of the company in return for your investment.

Implications

Pricing is opaque: While pricing is market-based, quick, and convenient, the cost of pricing an asset rather than valuing it is that the process glosses over details and makes it difficult to figure out what exactly is getting for the investment today and what is already incorporated in that number.

The Target rate is Swiss Army knife of VC valuation; In the VC approach, the target rate (though called a discount rate) is like a Swiss Army knife, serving multiple purposes.

First, it is a reflection of the expected return should make, given the risk in the investment, i.e., the conventional risk-adjusted rate.?

Second, it incorporates the survival risk in the company, i.e., the reality that many of the companies that VCs invest in don't make it and that have lower the value of start-ups to reflect this risk.

Third, it includes a component to cover the future capital needs of the business, with a higher discount rate being used for companies that will need more rounds of capital.

Finally, it is a negotiating tool, with VCs pushing up the target rate, if they feel that they have a strong bargaining position. While it is impressive that so much can be piled into one number, it does make it difficult to figure out whether have counted all of these variables correctly and not double-counted or miscounted it. It also implies that the actual returns generated by VCs will bear little resemblance to the target returns; the table below summarizes venture capital returns across VC funds over the last year, three years, five years, and ten years and compares them to returns on growth equity mutual funds.

Winners and Losers:?It is not clear who wins and loses in the pricing game when sloppiness rules. In periods where entrepreneurial investments are plentiful and venture capital funding is scarce, it probably leads to venture capitalists claiming too large a stake in the businesses that they invest in, given the capital invested. During periods when entrepreneurial investments are scarce and venture capitalists are plentiful it leads venture capitalists to overpay for businesses.

A Plea for Transparency

Venture capitalists and other early-stage investors shift to intrinsic valuation. While they underuse it and often misunderstand intrinsic valuation, further the attachment to pricing is too deep for them to shift. and to do believe though that everyone (founders, entrepreneurs, venture capitalists) would be better served if there was more transparency in the process and were more explicit about the basis for assessing ownership rights (and proportions).

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