The ins and outs of venture capital financing can get a bit confusing - multiple rounds, variable funding, term sheets - but (as often is the case) the most confusing part can simply be the math of valuation and ownership. How much is my company worth? How much of my share of the company worth? And what do they mean by pre-money and post-money valuation?

This is a huge topic, but we start by demystifying those last two terms.

Imagine you've 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.

How much is your company worth right now? How much is your equity worth?

Accounting will tell you that your company is worth the value of its assets, based on the initial cost of their acquisition, plus you cash on hand. The value of your ownership in the company will be 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, and that's the value of your company.

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But is that really the value? If you were to sell the company, you'd be selling it as a company, with a future and a customer base and an idea that has value. You certainly wouldn't be selling it for the value of the assets! And if you tried to sell your ownership stake, you couldn't just go out and sell it on the open market, like a stock. In fact, it might be very difficult for you to find someone who wants to buy your company as it is, or even buy the assets in their current state. So - one way you can think about it is that your company is worth either considerably more or considerably less than your balance sheet would suggest.

That's a bit frustrating.

Post-Money Valuation

This gets cleared up significantly once you receive your first round of venture capital funding. The venture capital firm will say something like, "Okay, we'll give you $1 million of funding, but we want to own 20% of your business in exchange." Now you have a valuation number to work with. 

If $1 million represents 20% of your ownership, than 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 received the venture capital financing.

Pre-Money Valuation 

Once we know the post-money valuation, we can determine the pre-money valuation. If the company is worth $5 million now, after receiving $1 million, then it must have been worth $4 million the moment before receiving that $1 million. $4 million 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 $100,000 and turned it into $4 million - you've created $3.9 million worth of value through your labors (this is sometimes called "sweat equity").

Stock Ownership

Another way to think about this is to think about stock ownership. Let's say that you issued yourself 10,000 shares of stock for your initial $100,000 investment. How much was each share worth? Well, accounting might say $10 each ($100,000 divided by 10,000), but that's not right for all the reasons we stated above. Your shares might be worth considerably more than $10. They might be worth nothing. You don't know.

Sticking with that example, if you currently own 10,000 shares of stock, what happens when the venture capital firm offers $1 million for 20% of your ownership? You'd simply issue them 2,500 shares (2,500 is 20% of 12,500, the new total number of shares). There are now 12,500 shares that represent $5 million in total ownership value - in other words, each share is now worth $400. Your sweat equity has created $390 worth of value.

And that's what entrepreneurs do - they take an idea, and they create value.

Brian Misamore

About the Author

Brian is a member of the HBX Course Delivery Team and was the lead content specialist for the Leading with Finance course on the HBX platform. He is currently working to build a course on entrepreneurship. 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.