Every start-up entrepreneur with a dream believes he has an excellent idea and raising money should not be a problem.Yet, it’s been noticed that getting adequate money to sustain a project is possibly the single most important challenge faced by any entrepreneur. A familiarity with the phrases below will help you avoid needlessly giving up equity, control and profits in the event of a successful exit.
Pre-money vs. Post-money Valuation
Let’s start very simply: valuation is the monetary value of your company. Internally, company shareholders often agree on a formula to determine valuation in the event of a partner’s death or exit. When looking for venture or angel financing, your valuation is, frankly, whatever you can convince investors to agree on.
The difference between pre-money valuation and post-money valuation is also very simple. Pre-money refers to your company’s value before receiving funding. Let’s say a venture firm agrees to a pre-money valuation of $10 million for your company. If they decide to invest $5 million, that makes your company’s post-money valuation $15 million.
Post-money valuation = pre-money valuation + new funding
Convertible Debt (Convertible Notes)
When a company is young, quantifying its valuation is often an arbitrary, pointless exercise. There may not even be a product in hand, let alone revenue. But companies at this stage may still need to raise money, and if investors decide on a pre-money valuation of say, $100,000, another $100,000 suddenly buys control.
Convertible debt (also called convertible notes) is a financing vehicle that allows startups to raise money while delaying valuation discussions until the company is more mature. Though technically debt convertible notes are meant to convert to equity at a later date, usually a round of funding.
Venture capital firms are issued preferred stock, rather than common stock in a company. Preferred stock comes with certain rights attached. One of these is liquidation preference.
Liquidation Preferences : Let’s be clear, the goal of financing companies is to eventually realize a payday. This event generally comes in the form of an acquisition or IPO. For less successful companies, a liquidation event could also come in the form of a bankruptcy. Liquidation preferences determine who gets paid what and when during these events. If the company goes bankrupt, for instance, there generally aren’t enough assets left to pay every creditor and shareholder the money their due. In this instance liquidation preferences determine the order in which everybody gets paid. Liquidation preferences are also relevant in a more successful outcome though.