pre-money and post-money
A conversation yesterday prompted me to republish this post from March 2011:
A very personal topic that’s unavoidable in every equity investment conversation is that when equity risk investment comes in, a percentage of the company must change hands (otherwise it’s not an equity investment). The investor needs the equity to drive their returns (and through taking some return in equity is sharing the risk with the management team) whilst the management/shareholders need the money to drive their equity returns and/or achieve their goals.
Clear need on both sides but highly emotive!
So how to assess what’s a ‘fair’ deal? Honestly, it’s an art and not a science, principally because it is predicated in the main on future value of equity and a subjective valuation of the equity of a business today.
However there are some basic principles that should be understood.
The management should take comfort that, even though they’ve been diluted, the economic value of their stake should have stayed the same and the prospects of their company increased (assuming of course this is a growth transaction). What does this mean?
I’ll try and outline a simple idea (introducing the concept of pre-money and post-money).
Lets take a company worth £1m today, with 100 shares in issue and 100% owned by management.
In this example, the pre-money (i.e. pre-investment) valuation is £1m and there are 100 shares in issue. An investor then offers £250k in equity investment. This £250k is equivalent to 25% of the pre-money (£1m) valuation and for it the investor would expect to receive 25 shares.
Now, the post-money (after investment) valuation of the business is £1.25m (i.e. original £1m value plus the £250k invested) and there are 125 shares in issue. The equity share is now 80% management, 20% investor (100/125 and 25/125 respectively). Management’s stake (80%) is still worth £1m (80% of £1.25m) but they now have a business that also has £250k of cash to deploy. As such, although they have been diluted managements’ economic value has stayed the same (£1m) but they are in a better position as they have £250k of cash to spend to enhance their equity value that they didn’t have before. An enhanced position that rationalises the decision.
However it points to the fact that you have really got to need the capital in order to raise it. The enhanced position is only there because the extra capital is now in the business to deploy. If this capital (£250k) is not deployed and/or ineffectively deployed then management have sold equity in their business for no real reason.
If the capital is not deployed then they have happy investors who are riding their 20% in a well run, well resourced business that took capital for no real purpose. Management have also therefore given away equity for money they didn’t need.
If the capital is ineffectively deployed then they have unhappy investors who have 20% of a business now worth £1m (or less) having spent its £250k to no effect. Equally management are unhappy because they now only have 80% of their £1m business.
Overall you need to understand why you need capital, what it does for your business and why it enhances value for both you and investors. If you can’t work out the answer to this last point before you raise funds then you shouldn’t be.