Leveraging venture capital (VC) financing can be a great way to turn your business from an idea into a reality, or to scale your existing business into a much larger entity. That being said, it can also be the source of significant confusion, especially for entrepreneurs without a finance background.
Between multiple rounds, variable funding, and term sheets, many entrepreneurs who turn to venture capital financing eventually ask themselves questions such as:
Here’s a breakdown of how to evaluate your company’s value in the context of venture capital funding.
Free E-Book:
So You Want to Be an Entrepreneur: How to Get Started
Access your free e-book today.
Imagine you put $100,000 into starting a new business, and you've been growing it for the last year. You think you have a viable product, and initial customer tests back up your claim. You're ready for venture capital funding. Before heading into a round of funding, you need to understand the value of your company.
According to basic accounting principles, your company is worth the value of its assets based on the initial cost of their acquisition, plus whatever cash you have on hand. The value of your ownership in the company is equal to the original $100,000 you put in, plus any retained earnings from your first year of operations. If you have any liabilities or debt, you can add those to give you a more accurate idea of the value of your company after its first year of operation.
Company Value = Assets - Initial Cost Of Acquisition + Cash
But does that really capture the company’s full value? Your company is more than just its assets—it’s an idea that has value, a customer base, and a future of potential. While putting a value to those intangibles can be difficult, it’s an essential part of understanding what your business is ultimately worth.
Essentially, your company is worth either considerably more or considerably less than your balance sheet would suggest, based on the value of its intangible assets. This brings us to post-money and pre-money valuations. These two methods can help you communicate your business’s value to venture capitalist firms or other VC funding sources.
Post-money valuation is the value of a company after an initial investment has been made.
This becomes clear once you receive your first round of venture capital investment. The venture capital firm or angel investor may offer you a specific amount of funding in exchange for a percentage of the ownership of your business. For example, they could offer you $1 million in funding in exchange for 20 percent ownership. Once you have an offer like this, you can calculate your business’s post-money valuation.
If $1 million represents 20 percent of the business’s ownership, then the total ownership must be worth $5 million. If you have no debt, that's the value of the entire business. This represents a post-money valuation of your business—in other words, this is the value after you receive venture capital financing.
Pre-Money valuation is the value of a company before receiving a venture capital investment.
Once you’ve calculated the post-money valuation, you can determine the pre-money valuation. If the company is worth $5 million after receiving $1 million in funding, then it must have been worth $4 million the moment before receiving that funding.
Four million dollars is the pre-money valuation of the company and the pre-money valuation of your ownership share. Another way to think about this is that your year of hard work has taken your original $100,000 investment and turned it into $4 million—you've created $3.9 million worth of value through your labors. This metric is sometimes called "sweat equity."
Another lens of valuation to consider is stock ownership. For instance, imagine you issued yourself 10,000 shares of stock for your initial $100,000 investment. How much was each share worth?
By doing some simple math, you may be tempted to say these shares are worth $10 each ($100,000 divided by 10,000), but that doesn’t take intangible assets into consideration. Your shares could be worth considerably more than $10, or they could be worth far less.
Now, imagine a venture capital firm offers you $1 million for 20 percent of the company’s ownership. You'd issue the VC firm 2,500 shares (2,500 is 20 percent of 12,500, the new total number of shares). Those 12,500 shares represent $5 million in total ownership value—in other words, each share is worth $400. In this scenario, your sweat equity has created $390 worth of value per share.
That's what entrepreneurs do—they take an idea and they create value, long term growth, and a return on their investment.
Every entrepreneur must be able to intelligently communicate the value of their business to themselves, their team, and their investors. Taking the time to study finance and accounting to learn the basic language and concepts can take you—and your business—far.
Are you looking to learn more about financing your business? Explore our four-week online course Entrepreneurship Essentials and our other entrepreneurship and innovation courses to learn to speak the language of the startup world.
This post was updated on September 17, 2021. It was originally published on August 24, 2017.
Brian is a former member of Harvard Business School Online's Course Delivery Team and was the lead content developer for Leading with Finance and Management Essentials. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.
