The Secret Math of Venture Capital and Valuations

Whenever an entrepreneur asks me for guidance I always say, “absolutely, but please read my blog first so you know how I see the world and then we can build from there.” I’m sure it’s incredibly annoying to them, but if I didn’t do it, well, then I wouldn’t have any readers at all. Honestly, my mom doesn’t even read the blog.

Anyway lately I’ve been explaining the secret math of venture capital a lot and I started thinking, “my god, didn’t I write about this? Why is everyone so interested in this?” I went back and sure enough the blog post, “How to Value Your Venture Capital Round” is a complete cop-out. I didn’t cover it at all. So be prepared to be wowed and amazed. This is the post that will change your life.

Pre-Money and Post-Money

As always, let’s start with the basics. When people talk about their valuation relative to a round of capital, you have to clarify whether they are talking PRE-money or POST-money. I tend to always think in terms of pre-money; any numbers disclosed publicly are probably post-money. What’s the difference? It’s easy. Pre-money is what the company is worth before the round closes. Post-money is simply the pre-money + the invested capital.

So let’s say the pre-money is $2 mil and the new investors agree to put in $1mil. The post-money will be $3mil. Two side notes that will help you keep up when firing numbers back and forth with potential investors:

• the price per share stays the same. So if in our example initially there are 4 mil shares outstanding, that means that on a pre-money basis, the shares are worth $.50. The new investors will buy their shares for that exact price, meaning they will get 2 mil new shares. At the end there will be 6 mil shares outstanding. $3mil post / 6 mil shares = $.50. Capital raising itself neither creates nor destroys value
• always calculate ownership off the post money. Here, new investors put in $1mil. The post-money is $3mil. Their stake is therefore 33%.

So, when a potential investor says, “I’ll value you at $2mil” make sure to listen for “pre-money” on the back of that. If they don’t clarify, it is neither tacky nor pretentious to say, “I assume you mean pre?”

 The Secret Math

OK, now that we’ve got the lingo, let’s get to the good stuff. What entrepreneurs always want to know – essentially – is what is the pre they should be asking for? But I’m here to tell you that it’s the wrong question to ask. The question is how much capital do you think you can raise.

What?  The key insight is that in every round you raise, the new investors are going to want to own somewhere between 20 and 50% of the company. And the heart of the range is where the real action is at….30 – 35%. The bottom line is that you’re giving up a chunk of your company.  Just accept it. It’s actually easier for most VCs and angels to write bigger checks then change the model and start accepting lower stakes.

So your true motivation as an entrepreneur is to get as much money in each of those rounds as you can and minimize your dilution by raising fewer rounds, not by maximizing the valuation in each round. Although – note – by maximizing capital in exchange for that 35%, you will also maximize the pre-money. So then, what’s the difference? The difference is that if you approach it as I’m suggesting, you’ll use different language that’s less “fixed pie” and more in line with the investors’ interests.

In another post, I’ll write about stages of development and what that typically means for how much capital you can raise at each.

Before I close, though, let me point out that Fred Wilson at Union Square – who many people believe to be the hottest investor on the planet at the moment – has explicitly said he doesn’t agree with the traditional model of, “get 35% in every round.” He’d rather write smaller checks for smaller stakes that leave managers with more ownership and less of his capital to burn through. Without a doubt, this has helped Fred become an owner of great start-ups like etsy and twitter. Maybe that’s the future of venture capital. But for now, I think you’re pretty safe following my guidance when Fred’s not in the room.