Shark Tank Pre-money & Post-money: The VC playbook
For those of you who have never watched an episode, it involves entrepreneurs (current or wannabe) pitching business ideas to five ‘sharks’, who then compete (if interested) in offering capital (cash) for a share of the business. Like some large families, we make even TV watching a competitive sport, especially when there are multiple shark offers on the table, with family members ranking the offers from best to worst. In one episode, a contestant was faced with two offers: the first shark offered $25,000 for 20% of the business and the second one jumped in with $100,000 for 50% of the business. While one family member suggested that the second offer was obviously better and everyone else in my family concurred, I was tempted to argue that it was not that obvious, but wisely chose to say nothing. A late night family gathering is almost never a good teaching moment, especially when your own children are in the audience.
Pre-money & Post-money: The VC playbook
In public company valuation, the contrast between pre-money and post-money valuations almost never is an issue, but in venture capital valuation, it is front and center. Given the central role it plays in venture capital investing, and the consequential effects it has both on capital providers and capital seekers, I assumed that the venture capital playbook would have detailed instructions on the contrast between pre-money and post-money valuation, but I was wrong. In fact, here is what I learned from the playbook. If you pay $X for y% of a business, the post-money value is the resulting scaled-up value and 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 in the last paragraph, you can compare the two offers now in post-money and pre-money terms:
Thus, the two offers effectively attach the same value to the business and at least on this dimension, the entrepreneur should find them equivalent. While the VC definition is technically right, it is sterile, because if you have a pre-money value for a business, you can always extract the post-money value, or vice versa, but both estimates are only as good as your initial value estimate. It is also opaque, because the process by which value is estimated is often unspecified and and made more so when the simple exchange of capital for a share of ownership is complicated by add ons, with options to acquire more of the business, first claims on cash flows and voting rights thrown into the mix.
While some of the opacity that accompanies pre-money and post-money valuations is related to the fact that you are dealing with young, start-ups, often without operating histories or clear business models, I believe that some of it is by design. By leaving the discussion of value vague and/or making the exchange of capital for proportion of the business complicated, venture capitalists can create enough noise around the process to confuse entrepreneurs about the values of their businesses. By the same token, the sloppiness that accompanies much of the discussion of pre-money and post-money valuations in venture capital can also lead to excesses during periods of exuberance, where the fact that too much is being paid for a share of a business is obscured by the confusion in the process.
Pre-money and Post-money in an Intrinsic Value World
I know that intrinsic valuations (and DCF valuations, a subset) are considered to be unworkable by many in the venture capital community, with the argument given that the young, start-ups that VCs have to value do not lend themselves easily to forecasting cash flows and/or adjusting for risk. I disagree but I think that even if you are of that point of view, the path to understanding pre-money and post-money values is through the intrinsic valuation of a very simple business.
The Franchise Stage
Let’s assume that you are politically connected and that the government has given you a license to build a toll road. The cost of building the road is $100 million and to keep things really simple, let’s assume that the government has agreed to pay you $10 million a year in perpetuity, that you live in a tax-free environment and that the long-term government bond rate is 5%. To get a measure of the value of the license, all you have to do is take the present value of the expected cash flows, net of the cost of building the road:
NPV of road = -100 + 10/.05 = $100
While a conventional accounting balance sheet would show no assets and no value for the business (since the road has not been built), an intrinsic value balance sheet will show this value:
Note that the $100 million value attributed to you (as the equity investor) in the intrinsic value balance sheet is based on a notional toll road, not one in existence.
The Capital Seeking Stage
Now, let’s assume that you don’t have the capital on hand to build the road and approach me (a venture capitalist) for $100 million in capital that you plan to use to build the road. Assuming you convince me of the viability of the business and that I invest $100 million with you, here is what the balance sheet will look like the instant after I invest.
Note that the business value has doubled to $200 million, with half of the value coming from the cash infusion. That cash is transitory and will be used by you to invest in the toll road, and the minute that investment is made, the balance sheet will reflect it.
While the value of the business has not changed from the post-cash number, the nature of its assets has, with a physical toll road now setting value, rather than a license and cash. Thus, the value of the business after the cash infusion is $200 million and this is the post-money valuation of the company.