Pre-money valuation, Post-money valuation, cap, discount rates, etc. are all terms a founder has to learn about as she is raising capital. Unfortunately, it’s a new concept for most of us. Below you’ll find a simple definition and two ways how it can affect a founder:
Pre-money valuation refers to the value of a company before an investment is made, while post-money valuation is the company's valuation after all the investment is added. Think of a glass of water: pre-money valuation is the value of the glass, and post-money valuation is the value of the glass plus the water (the investment) added to it. This seems minor, but it can significantly impact a founder.
This happens in two ways:
First, let’s say an investor is investing $2M at a $10M valuation. If that $10M is pre-money, the effective post-money valuation is $12M. If that $10M valuation is post-money, the pre-money valuation is actually $8M. This affects your equity but can also affect your next round of fundraising or exit potentials.
Second, let’s say you are raising a Convertible Note round. In this hypothetical example, the founder and investors have agreed on a valuation cap of $8 million. They are using the pre-money valuation method. The investor is investing $2 million. This will essentially lead to a post-money valuation of 10 million dollars. Another founder is raising a similar deal but has agreed on a post-money valuation cap of $10M. At first glance, these two deals look similar. But there is an important thing to keep in mind.
Now, let's say you are actually able to raise $3M. Most people will say to raise more than you need if the terms are favorable. In the case of pre-money valuation, it would be the pre-money valuation of $8M, and post-money of $11M. But raising on a post-money cap, the dilution affects the founders the most, i.e. the post is fixed, so it essentially becomes $7M pre, resulting in $10M post. In this case, the founder ended up with 72.7% equity in the first case and 70% equity in the second case. The gap widens as the additional raised amount increases.
An investor will prefer a post-money cap option. Rightfully so, as it limits their dilution. As a founder, you should opt for a pre-money cap as it allows you to raise more without the founder having to carry all the burden of dilution. In the pre-money example, the dilution is spread out between the founders and original investors.
As a founder, you may not have the final say in the terms, but it is still essential to understand what they mean for you and your team so you can make an informed decision.
P.S.- The examples above are oversimplified. In real life, there are multiple other things to consider.