Start-up Valuation : Pre-Money and Post-Money Valuation

Readers,

I am quickly jotting down a note on Pre-Money and Post-Money Valuation.

It is defined that

  • The premoney valuation is the value of the existing venture and its business plan without the proceeds from the contemplated new equity issue.
  • The post-money valuation is the pre-money valuation plus the proceeds from the contemplated new equity issue.
One thing that I am trying to understand as to why the Post-Money Valuation is just as simple as adding the new investment Dollar onto the Pre-Money Valuation.

There are two points I would like to note down:

(i) As Pre-Money valuation is the valuation of the assets-in-place, then by injecting the new investment, the business might use that new injection to scale up its existing business even more, higher than the initial projected cash flows. The venture could invest that new injection to buy more stock, hire more qualified engineers and resources, etc. Then where will all this higher positive cash flows be reflected into the Post-Money Valuation?

(ii) if all those higher positive cash flows generated by investment funded by the new injection (assuming the money from the new Venture Capital (VC) flowing into the company or business and not to the existing founders), is not factored into the Post-Money valuation, then there is an assumption that the NPV from the perspective of the Venture Capital from investment in that new venture is ZERO.

NPV (Buy security) = PV (All cash flows paid by the security) – Price (Security) = ZERO.

This assumption that NPV of buying security in the new venture is ZERO might make sense, since if the NPV of buying a security were positive, then this would present an arbitrage opportunity, since positive NPV will mean that the VC is to receive a cash today (at the time of the injection being made to the new venture). Since this arbitrage opportunities theoretically do not exist in the normal markets, then the NPV of buying a security in the new venture is ZERO, meaning the trading securities should not create or destroy the value  (note : financing or financial transactions should be neutral in this case, and its presence is just to adjust the timing and risk of the cash flows to best suit the needs of the firm or investors). The real value should come from the real investment being engaged by the company (Modigliani-Miller proposition, which is pretty much about the conservation of value, or separating investment and funding activities).

If the (ii) sounds OK, then my next question, if the NPV of buying security is ZERO, then why the VC wants to inject the money to the new venture in the first place?

My initial argument is, VC could see that somehow though NPV of buying a security is ZERO, yet, the business might have upside potential in the future that could produce more income (or cash) than initially forecasted. Meaning with VC required rate of return (in the book’s example, using 50%  compound annual rate of return), the actual return could turn out to be much higher rate of return (as a footnote, VC requires really high rate of return as the potential for realizing that expected return from all its portfolio might be only 10% success rate, and the rest is a fall-out).

Prof. PDM to Karnen:

It is just definitional.  Pre-money includes the value generated by the new investments as well, but which goes to the existing investors.

Karnen to Prof. PDM:

I agree with you, the money flowing to the Venture should somehow play a role in having the venture to execute positive NPV projects, otherwise, the VC will not be willing to invest.

Respondent 1 to Karnen:

Note: the respondent’s response is in italics.

Responding to this :  the  definition of:

  • The premoney valuation is the value of the existing venture and its business plan without the proceeds from the contemplated new equity issue.
  • The post-money valuation is the pre-money valuation plus the proceeds from the contemplated new equity issue.

One thing that I am trying to understand as to why the Post-Money Valuation is just as simple as adding the new investment Dollar onto the Pre-Money Valuation.

The main reason that we can usually just add the proceeds to the Pre-Money to get the Post-Money is due to the assumption made regarding the return to new investors. As the deal is “priced” using a required return, providing that return is NPV=0.  Therefore, the equity issue neither adds nor subtracts anything in terms of NPV (dollar value above required return), but adds the proceeds to the total post-offering PV.

There are two points I would like to raise up:

(i) As Pre-Money valuation is the valuation of the assets-in-place, then by injecting the new investment, the business might use that new injection to scale up its existing business even more, higher than the initial projected cash flows. The venture could invest that new injection to buy more stock, hire more qualified engineers and resources, etc. Then where all this higher positive cash flows be reflected into the Post-Money Valuation?

The Pre-Money value is the value of the existing assets/operations in place and the value of all options to expand. New investors are paid required returns (not NPV), leaving any return above the required (any NPV) to the existing Pre-Money owners.  This Pre-Money value of the PV of existing operations and any NPV from intended expansion-option projects (after raising the money and paying a required return (NPV-0 to new investors) includes the NPV of the type of projects you suggest.  Put differently, the “N” part belongs to existing owners; the “PV” part belongs to the investors providing the new capital as their investment is priced at the required rate of return for NPV=0 on their injection.

(ii) if all those higher positive cash flows generated by investment funded by the new injection (assuming the money from the new VC flowing into the company or business and not to the existing founders), is not factored into the Post-Money valuation, then there is an assumption that the NPV from the perspective of the Venture Capital from investment in that new venture is ZERO.

(This is the assumption since we’re using a required return for competing investors considering this type of investment and risk.)

NPV (Buy security) = PV (All cash flows paid by the security) – Price (Security) = ZERO.

This assumption that NPV of buying security in the new venture is ZERO might make sense, since if the NPV of buying a security were positive, then this would present an arbitrage opportunity, since positive NPV will mean that the VC is to receive a cash today (at the time of the injection being made to the new venture). Since this arbitrage opportunities theoretically do not exist in the normal markets, then the NPV of buying a security in the new venture is ZERO, meaning the trading securities should not create or destroy the value  (note : financing or financial transactions should be neutral in this case, and its presence is just to adjust the timing and risk of the cash flows to best suit the needs of the firm or investors). The real value should come from the real investment being engaged by the company (MM proposition, which is pretty much about the conservation of value, or separating investment and funding activities).

If the (ii) sounds OK, then my next question, if the NPV of buying security is ZERO, then why the VC wants to inject the money to the new venture in the first place?

(To make the required return they have calibrated and a competitive market agrees is the “going rate” for that type of investment and risk. The key here is that when we use a discount rate like 50%, we have assumed that such a rate is competitively available to the venture to move money across time. Otherwise the discounting to get value doesn’t make sense. All monies (from existing and new investors) moves across time at that same rate (assuming they have the same claim and risk). This is embedded in the notion that we are allowed to make the time-value adjustments using a single discount rate at each point in time.)

My initial argument is, VC could see that somehow though NPV of buying a security is ZERO, yet, the business might have upside potential in the future that could produce more income (or cash) than initially forecasted. Meaning with VC required rate of return (in the book’s example, using 50%  compound annual rate of return), the actual return could turn out to be much higher rate of return (as a footnote, VC requires really high rate of return as the potential for realizing that expected return from all its portfolio might be only 10% success rate, and the rest is a fall-out).

(It appears that you have worked through the rationale. I think your concern is more fundamental than our textbook application, however.  That is, the concern is not just about discounting in the venture investing context. The same concern would apply to the use of a required discount rate for project financing in a mature company. When we use a required discount rate to impose the new investors’ claims on the cash flow stream (taking the rate to be the competitively offered rate that is appropriate for the investment and risk), we have assumed that all NPV from the funded project goes to existing investors.  This is the same as saying the present value of the new money is equal to the discounted value of future cash flows at the required return. If we have to give some NPV to the new investors, then the “required” return is higher than the return we’re asserting is the “required” return.  Again, this is a fundamental assumption involved in discounting using “required” returns – there is a competitive fringe of investors that can only successfully demand the market-determined required rate of return. You don’t have to pay them above that amount. You cannot get their money for less. This means that the NPV goes to existing owners of the right to take the new capital and create something beyond the required return on that new capital. Existing investors get the NPV in such a context. Perhaps it would help to think of the expansion rights as something like a patent that can only be used by its owners.)

Karnen to Respondent 1:

From reading your comments, it sounds to me that the first investor and second investor will be compensated with MAX the required rate of return. If this is the case, then the investor’s money in nature is similar to DEBT, which means they will only get what is PROMISED to them from investing their money into the venture. Then all NPV, or any ACTUAL return from the venture above the required rate of return, then this will go to the founder(s). If this is correct, then the first and second round will only have downside risk, but can’t enjoy the upside potential of the venture.

The reference to the Exit Value at Period_t-1 (fifth year in the case being shown). This “Exit value” could mean anything, I gather, not necessarily, the venture will really free-flow the money to the investors and founders.

Yes, the exit value is just an imposed horizon value that could be from a conjectured IPO, acquisition or private equity buyout of one’s investment.  For example, if one considers the IPO the event for that horizon, it is not (in the U.S.) typically a liquidity event given that insiders typically are locked up for 6 more months. Nonetheless, we can think of the IPO price as some type of valuation to “mark to market” the locked-up investors’ investments. Their eventual realized proceeds could be more or less than the IPO price.

In many books I read about the Silicon Valley success stories, the Exit here will mean the successful IPO, for example, eBay, Netscape, Google, Facebook, Twitter, etc. So in the case of IPO, since there is no money free-flowing to the investors (both first round and second round) from the venture, but the 1st and 2nd investors if they want, they could sell their shares to the public as well (or offer their shares to other private investors), then the ACTUAL rate of return to the 1st and 2nd round investor, will not be limited to the required rate of return they put in the first place. If this is correct, then this is not in line with what I understand from the one I explained above which 1st and 2nd round investor return profile will be similar to DEBT, in other words, their return will be MAX to the required rate of return..

When we use a discount rate on expected cash flows to get a value today that is paid by an investor that investor owns a security with those expected cash flows. When actual cash flows are realized, then the rules of the security (the security’s position in the waterfall) determines the actual/realized cash flows which can be more or less than those that were “expected” when the security was purchased. It is true that some securities will have levels where additional cash flows “knock in” or “knock out.” That is, the security’s legal structure can allow for acceleration or deceleration of participation in cash flows at various levels.  Whether the participation level starts, stops, accelerates or decelerates is part of the negotiation when the security is created/purchased. Traditional debt knocks out its participation in cash flow above the level of its principal and accrued interest. Traditional equity knocks in when debt claims have been serviced. Hybrid securities can have both debt-like and equity-like claims. If those are to have max and min characteristics (usually referred to as “participation” in VC investments) they should be specified in the legal documents defining the securities at the time of purchase. 

The valuation approaches treat the securities as they would produce flows in “upside scenarios,”  i.e., as if converted to equity.  If one wanted to base the valuation on a larger (broader than the three we consider) scenarios where detailed treatment of “downside scenarios” and liquidation preferencing, etc. is taken into account, then one would need to have a mathematical description of the waterfall specification and then proceed to consider more scenarios and their likelihoods.  Our observation of much of the early-stage venture financing is that such detailed inclusion is seldom considered to be a significant component of the price to which venture investors agree.  More often, the value appears to be based on some “upside scenario” and the associated realized returns in those scenarios (X% per year or 3X, 5X or 10X on investment, etc.). Perhaps this is a concession to the large amount of complete write-offs for failed ventures (where even the debt-like preferencing doesn’t provide much in the way of cash flow). Of course, 50-100% is clearly not an “expected” return. It is a “utopian” return targeted for successful investments so that overall portfolio returns will be reasonable (given that many of the investments are 100% losses).

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