“Diversification of risk matters not just defensively, but because it maximizes returns as well, because we expose ourselves to all of the opportunities that there may be out there.” — Peter Bernstein
Y Combinator is one of the most famous accelerators in the world, some of the companies that have gone through its program are Airbnb, Doordash, Stripe, Instacart, Coinbase and GitLab. Y Combinator invests USD$125k for a 7% stake in these companies using a post-money cap SAFE (Simple Agreement for Future Equity) which results in an implicit valuation of USD$1.8mm. After the YC Demo Day, startups close rounds or continue their capital raising processes at valuations that can be between USD$8mm and USD$90mm. Usually startups use a SAFE whose valuation cap can be pre-money or post-money. Have you ever wondered what the difference is between these?
The valuation of a company is the estimate of future cash flows brought to present value. In the case of seed stage startups, it is simply this simplified estimate. The pre-money value is the value of the startup before an investor’s capital investment. The post-money value is the new value of the startup already considering the capital investment.
Both pre-money and post-money are used to calculate the shareholders participation. When the valuation is pre-money, the total amount of the capital raise must be added to it so that the investor has a real value of his stake. In the other side the agreed value serves as a limit for the investor to calculate its participation. In other words, assume that a startup is raising USD$1mm with a pre-money valuation of USD$10mm. In this case, the stake of the new investors would be 9.09%. On the other hand, considering the same example at a valuation of USD$10mm post-money, the stake of the investors would be 10% at the end of the equity round regardless of whether additional capital was raised.
The pre-money and post-money valuations serve as indicators to determine the relative valuation of the company in relation to market comparables. That is, you can use valuation multiples with both values and compare them with comparable companies or in a similar stage of development, determining the under or over valuation of the startup.
Furthermore, by comparing the pre-money valuation of the previous round with the same concept of the current round, we can analyze the generation of value of a startup between one round and another. On the other hand, when comparing the post-money valuation of the previous round with that of the current round, we can visualize the real growth of the startup in this period.
Considering the application of pre-money and post-money values in convertible notes or SAFEs, it should be considered that the investor is usually benefited by using post-money since it is a valuation cap. On the contrary, the entrepreneur tends to benefit from the pre-money, especially if the amount raised is significant, thus mitigating the expected dilution.
In a capital raising round understanding pre-money and post-money is not enough, you must also consider whether the round is a flat round or a down round.
In all capital raising, it is sought that the valuation increases (Up round), this is important for both the entrepreneur and investors, it also sends a positive message to the market indicating that the startup is having a positive development, which generates interest in other investors to invest in it.
Sometimes due to market contingencies or due to a lower traction than expected at the time of raising capital, the valuation is equal to the previous round (flat round), this means that there has not been a capital appreciation for the investors. However, the startup continues to need additional capital to continue with its operations.
The least favored case is when there is a down round valuation; that is, the valuation of the current equity round is lower than that of the previous round. This happens when the valuation of the previous round was not established correctly, overestimating the value of the company, when the performance of the startup is much worse than estimated or when market conditions changed leading to a decrease in valuations, among others.
When a round is undervalued, there are clauses that can protect the investor from the loss of value of his initial investment. For example, the anti-dilution clause protects the investor of the company by granting more shares for free so that its participation does not decrease as a result of a lower valuation.
An overestimation of value is common in startups, as well as an excess of confidence on the part of the founders when determining the performance expectations of the startups. Therefore, always have a critical judgment when valuing the company and establish clauses that protect you as an investor against potential contingencies. Remember “wish for the best and plan for the worst”.
“Investors need to pick their poison: Either make more money when times are good and have a really ugly year every so often, or protect on the downside and don’t be at the party so long when things are good.” — Seth Klarman
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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