Latepost Blood Inwards The Shark Tank: Pre-Money, Post-Money In Addition To Play-Money Valuations

My kids are inclined to binge TV-watching, peculiarly inwards the winter, as well as this Christmas break, when they were all home, they were at it again. Having gone through all the Walking Dead episodes during the summertime as well as  Criminal Minds multiple times, they chose Shark Tank every bit the present to scout inwards marathon format. For those of y'all who receive got never watched an episode, it involves entrepreneurs (current or wannabe) pitching concern ideas to v 'sharks', who so compete (if interested) inwards offering working capital missive of the alphabet (cash) for a percentage of the business.  Like some large families, nosotros brand fifty-fifty TV watching a competitive sport, peculiarly when in that location are multiple shark offers on the table, alongside theater unit of measurement members ranking the offers from best to worst. In ane episode, a contestant was faced alongside ii offers: the starting fourth dimension shark offered $25,000 for 20% of the concern as well as the 2nd ane jumped inwards alongside $100,000 for 50% of the business. While ane theater unit of measurement fellow member suggested that the 2nd offering was manifestly improve as well as everyone else inwards my theater unit of measurement concurred, I was tempted to fence that it was non that obvious, but wisely chose to say nothing. H5N1 belatedly nighttime theater unit of measurement gathering is almost never a skillful teaching moment, peculiarly when your ain children are inwards the audience. 

Pre-money & Post-money: The VC playbook

In world companionship valuation, the contrast betwixt pre-money as well as post-money valuations almost never is an issue, but inwards venture working capital missive of the alphabet valuation, it is front end as well as center. Given the fundamental role it plays inwards venture working capital missive of the alphabet investing, as well as the consequential effects it has both on working capital missive of the alphabet providers as well as working capital missive of the alphabet seekers, I assumed that the venture working capital missive of the alphabet playbook would receive got detailed instructions on the contrast betwixt pre-money as well as post-money valuation, but I was wrong. In fact, hither is what I learned from the playbook. If y'all pay $X for y% of a business, the post-money value is the resulting scaled-up value as well as netting out the cash influx yields the pre-money value:

• Post-money value = $X/y%
• Pre-money value = $X/y% - $X

Using the Shark Tank episode inwards the final paragraph, y'all tin compare the ii offers straight off inwards post-money as well as pre-money terms:

Thus, the ii offers effectively attach the same value to the concern as well as at to the lowest degree on this dimension, the entrepreneur should honor them equivalent. While the VC Definition is technically right, it is sterile, because if y'all receive got a pre-money value for a business, y'all tin ever extract the post-money value, or vice versa, but both estimates are alone every bit skillful every bit your initial value estimate. It is also opaque,  because the procedure past times which value is estimated is oft unspecified as well as and made to a greater extent than so when the unproblematic telephone substitution of working capital missive of the alphabet for a percentage of ownership is complicated past times add together ons, alongside options to acquire to a greater extent than of the business, starting fourth dimension claims on cash flows as well as voting rights thrown into the mix.

While some of the opacity that accompanies pre-money as well as post-money valuations is related to the fact that y'all are dealing alongside young, start-ups, oft without operating histories or clear concern models, I believe that some of it is past times design. By leaving the give-and-take of value vague and/or making the telephone substitution of working capital missive of the alphabet for proportion of the concern complicated, venture capitalists tin create plenty noise simply about the procedure to confuse entrepreneurs almost the values of their businesses. By the same token, the sloppiness that accompanies much of the give-and-take of pre-money as well as post-money valuations inwards venture working capital missive of the alphabet tin also Pb to excesses during periods of exuberance, where the fact that likewise much is beingness paid for a percentage of a concern is obscured past times the confusion inwards the process.

Pre-money as well as Post-money inwards an Intrinsic Value World

I know that intrinsic valuations (and DCF valuations, a subset) are considered to endure unworkable past times many inwards the venture working capital missive of the alphabet community, alongside the declaration given that the young, start-ups that VCs receive got to value practise non lend themselves easily to forecasting cash flows and/or adjusting for risk. I disagree but I intend that fifty-fifty if y'all are of that indicate of view, the path to agreement pre-money as well as post-money values is through the intrinsic valuation of a really unproblematic business.

The Franchise Stage

Let's assume that y'all are politically connected as well as that the authorities has given y'all a license to create a toll road. The cost of edifice the route is $100 ane thou one thousand as well as to hold things actually simple, let's assume that the authorities has agreed to pay y'all $10 ane thou one thousand a twelvemonth inwards perpetuity, that y'all alive inwards a tax-free environs as well as that the long-term authorities bond charge per unit of measurement is 5%. To acquire a mensurate of the value of the license, all y'all receive got to practise is receive got the introduce value of the expected cash flows, internet of the cost of edifice the road:

• NPV of route = -100 + 10/.05 = $100

While a conventional accounting residuum canvass would present no assets as well as no value for the concern (since the route has non been built), an intrinsic value residuum canvass volition present this value:

Note that the $100 ane thou one thousand value attributed to y'all (as the equity investor) inwards the intrinsic value residuum canvass is based on a notional toll road, non ane inwards existence. 

The Capital Seeking Stage

Now, let's assume that y'all don't receive got the working capital missive of the alphabet on manus to create the route as well as approach me (a venture capitalist) for $100 ane thou one thousand inwards working capital missive of the alphabet that y'all programme to work to create the road. Assuming y'all convince me of the viability of the concern as well as that I invest $100 ane thou one thousand alongside you, hither is what the residuum canvass volition expression similar the instant afterwards I invest.

Note that the concern value has doubled to $200 million, alongside one-half of the value coming from the cash infusion. That cash is transitory as well as volition endure used past times y'all to invest inwards the toll road, as well as the infinitesimal that investment is made, the residuum canvass volition reverberate it.

While the value of the concern has non changed from the post-cash number, the nature of its assets has, alongside a physical toll route straight off setting value, rather than a license as well as cash. Thus, the value of the concern afterwards the cash infusion is $200 ane thou one thousand as well as this is the post-money valuation of the company. 

The Negotiation Stage

The inquiry at this indicate is what proportion of your concern I should acquire every bit the venture capitalist. At starting fourth dimension sight, the response may appear obvious. The value of the business, afterwards the working capital missive of the alphabet infusion (and investment) is $200 million, as well as the working capital missive of the alphabet I am providing is $100 million, entitling me to 50%, right? Not so fast! The actual response volition depend upon your bargaining might (as the entrepreneur) as well as mine (as the venture capitalist), as well as the easiest means to run into this is inwards the limiting cases:

• Case 1 - Only entrepreneur inwards market, Lots of working capital missive of the alphabet providers: Assume that y'all are the alone entrepreneur alongside a valuable franchise inwards the economic scheme as well as in that location is a large provide of working capital missive of the alphabet (from banks, venture capitalists, mortal equity investors). You (as the entrepreneur) receive got all the might inwards this negotiation as well as I volition destination upwardly alongside a 50% percentage of the post-money valuation ($200 million).
• Case 2 - Lots of entrepreneurs alongside valuable franchises, a monopolist working capital missive of the alphabet provider: At the other extreme, if I (the VC) am the alone game inwards town for capital, I volition fence that without me your franchise is worth nothing, as well as that I should destination upwardly alongside all of the value (thus giving me closed to 100% of the business). 

The reality volition autumn somewhere inwards the middle. In general, the value that y'all volition work to compute your per centum ownership volition endure neither the pre-money, nor the post-money value. It volition endure the value of the business, alongside the adjacent best working capital missive of the alphabet provider providing the $100 ane thou one thousand inwards capital. In the toll route example, assume that y'all tin borrow $100 ane thou one thousand from a banking concern at 7.5%, a charge per unit of measurement that is much likewise high, given the risk of the investment (zero). The value of your equity inwards this toll route volition straight off receive got to reverberate the involvement payments on this debt.

Cash flows afterwards debt payments = $10 ane thou one thousand - .075 (100) = $2.5 million

Value of equity = $2.5 million/.05 = $50 million

The novel residuum canvass of the concern volition reverberate this expensive debt:

Note that the banking concern has effectively claimed $50 ane thou one thousand of the value of the concern past times charging y'all likewise high a charge per unit of measurement as well as netting out the bank's surplus yields a value of $150 ane thou one thousand for the toll road, the "ownership value", since the ownership stake volition endure based on it. As the venture capitalist, I recognize that this is your adjacent best choice as well as demand two-thirds of your concern for my $100 million. In summary, so the ownership per centum of your concern that I volition acquire inwards render for my working capital missive of the alphabet provision tin hit from 50% to closed to 100%, depending on the relative  supply of entrepreneurs as well as venture working capital missive of the alphabet inwards a market.

Implications

1. H5N1 DCF valuation, done right, ever yields a pre-money value for a business.

2. The value of a business, afterwards a working capital missive of the alphabet infusion, volition receive got to comprise the cash that comes into the business, pushing upwardly the post-money value.

3. The "ownership value on which the ownership proportion is negotiated volition motion towards the post-money value, when in that location is an active as well as competitive (venture) working capital missive of the alphabet market, as well as towards the pre-money value, when in that location is non one.

The Pricing World: Pre-money or Post-money?

As I noted at the start of the final section, most venture capitalists swear off DCF for many reasons, some justified as well as some not. Instead, they toll businesses using a combination of a forecasted metric as well as a multiple of that metric (given what others are paying for similar businesses right now). Thus, if y'all were valuing a start-up money-losing technology theater alongside no revenues today, y'all would forecast out revenues 3 years (or five) from straight off as well as apply a multiple to those revenues (based on what the marketplace is paying for world companies inwards this space) inwards the 3rd twelvemonth to acquire an travel out value, which y'all volition so continue to discount dorsum at a "target" charge per unit of measurement of render to acquire a value today:

Pricing: Pre or post-money?

When y'all toll companies, the inquiry of whether the value y'all acquire inwards at today is a pre-money or post-money valuation becomes murkier. The forecasted revenues that y'all forecast inwards twelvemonth 3 is non (and oft are) alone based on the supposition that in that location is a working capital missive of the alphabet infusion inwards the theater today but that in that location may endure to a greater extent than working capital missive of the alphabet infusions inwards the future, inwards which instance it is a post-post-post coin valuation as well as adding cash to this value volition endure double counting. (As an analogy, consider the toll route illustration that I used inwards the intrinsic value section. The earnings on the toll route are expected to endure $10 ane thou one thousand a twelvemonth as well as the toll route should merchandise at almost 20 times earnings, given its fundamentals. Using the VC approach, the value that I would acquire is $200 million, which is the post-money valuation). 

A pre-money pricing?

Can y'all modify the VC approach to deliver a pre-money pricing? Yes, as well as hither is what y'all would receive got to do. You would receive got to forecast ii measures of hereafter earnings, ane alongside the working capital missive of the alphabet infusion as well as ane without. In the extreme scenario where the start-up volition cease to be without the working capital missive of the alphabet as well as in that location are no other working capital missive of the alphabet providers, the expected earnings inwards twelvemonth 3 volition endure zero, yielding a pre-money valuation of null for the company. Consequently, y'all volition demand all or almost all of the companionship inwards render for your investment.

Implications

1. Pricing is opaque: While pricing is market-based, quick as well as convenient, the cost of pricing an property rather than valuing it is that the procedure glosses over details as well as makes it hard to figure out what precisely y'all are getting for your investment today as well as what y'all receive got already incorporated inwards that number. 
2. The Target charge per unit of measurement is Swiss Army knife of VC valuation; In the VC approach, the target charge per unit of measurement (though called a discount rate) is similar a Swiss Army knife, serving multiple purposes. First, it is a reflection of the expected render y'all should make, given the risk inwards the investment, i.e., the conventional risk-adjusted rate.  Second, it incorporates the survival risk inwards the company, i.e., the reality that many of the companies  that VCs invest inwards don't brand it as well as that y'all receive got to lower the value of start-ups to reverberate this risk. Third, it includes a constituent to encompass the hereafter working capital missive of the alphabet needs of the business, alongside a higher discount charge per unit of measurement beingness used for companies that volition involve to a greater extent than rounds of capital. Finally, it is a negotiating tool, alongside VCs pushing upwardly the target rate, if they experience that they receive got a potent bargaining position. While it is impressive that so much tin endure piled into ane number, it does brand it hard to figure whether y'all receive got counted all of these variables correctly as well as non double counted or miscounted it. It also implies that the actual returns generated past times VCs volition behave niggling resemblance to the target returns; the tabular array below summarizes venture working capital missive of the alphabet returns across VC funds over the final year, 3 years, v years as well as 10 years as well as compares them to returns on increase equity usual funds as well as the S&P 500.

   

   Through Sept 30, 2014; Source: National Venture Capital Association (NCVA)

3. Winners as well as Losers: It is non clear who wins as well as loses inwards the pricing game, when sloppiness rules. In periods where entrepreneurial investments are plentiful as well as venture working capital missive of the alphabet funding is scarce, it in all probability leads to venture capitalists claiming likewise large a stake inwards the businesses that they invest in, given the working capital missive of the alphabet invested. During periods when entrepreneurial investments are scare as well as venture capitalists are plentiful, my guess it that it leads venture capitalists to overpay for businesses.

A Plea for Transparency

I am non making an declaration that venture capitalists as well as other early on phase investors shift to intrinsic valuation. While I believe that they nether work as well as oft misunderstand intrinsic valuation, I intend that the attachment to pricing is likewise deep for them to shift. I practise believe though that everyone (founders, entrepreneurs, venture capitalists) would endure improve served if in that location was to a greater extent than transparency inwards the procedure as well as nosotros were to a greater extent than explicit almost the footing for assessing ownership rights (and proportions). Perhaps, I volition start past times making myself unpopular inwards my household as well as bringing upwardly the give-and-take of pre as well as postal service coin valuations during Shark Tank!

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