When a business decides that it must raise capital, a key question to be answered is how much the business is worth. For example, if the company needs $ 500,000 to start and / or grow, what percentage of that company’s equity should it get $ 500,000? Once this question is answered, the company will go out and try to find investors. In doing so, a key question often arises as to whether the valuation is “before the money” or “after the money.”
“Before money” or “pre-money” and “after money” or “post-money” denote simple concepts. However, these simple concepts can confuse even the most sophisticated analysts at times. If a business is valued at $ 1 million on day 1, then 25 percent of the business is worth $ 250,000. However, there may be an ambiguity. Suppose the company and the investor agree on two terms: (1) a valuation of $ 1 million and (2) an equity investment of $ 250,000. In this case, the company can offer the investor 250 shares for $ 250,000. There may be a disagreement immediately. The investor may have thought that the company’s equity was worth $ 1,000 per percentage point, in which case $ 250,000 gets 250 out of 1,000 shares or a 25% equity position. Rather, the company may have believed that the investor was contributing to the company, which was already worth $ 1 million. Under this reasoning, the $ 250,000 would give the investor 250 shares of 1,250 shares or a 20% equity position.
The fundamental question was whether the agreed value of $ 1 million to be assigned to the company was before or after the investor’s contribution in cash (pre-money) or post-money.
In the above case, a pre-money valuation of $ 1 million and a post-money valuation of $ 1.25 million were equivalent. Because mixing the terms could significantly increase the cost of capital raised, companies should make sure they understand both metrics and agree with investors on the metric that increases their capital at the right price.