Where capital and opportunity meet
If you own a piece of land worth $100,000 then spend $200,000 building a house on that land,in a simple world, the entire property is worth $300,000. What you started with, the land, is nowone-third the value of the whole asset. The new investment, the house, is worth two-thirds. Thisis similar to how a private equity investment may work. If your company is worth $100,000 thenyou raise $200,000 from investors, the company would be worth $300,000 after the investment ismade. You would own one-third of the company after the investors buy the other two-thirds withtheir $200,000. This $200,000 is the “money” in the terms “pre-money value” and “post-moneyvalue.”
Pre-money value: $100,000+ Investment (i.e. “money in”): $200,000= Post-money value: $300,000
Many home owners want to argue that, sure the tax assessor may appraise the total propertyat $300,000, but I could sell it for more than that! Given the real estate market in recent years,that’s probably true. But here’s the question – what if someone else spent the money to buildthe house on your land and you sold the property together; how would you split the proceeds?The simplest answer is to look at the value each contributed, assume the entire propertyappreciated or depreciated together, and share accordingly.Likewise, many entrepreneurs want to argue that their company is worth more than the $300,000in this example. Assuming they spend the $200,000 from the investors wisely, the companyshould be worth more than $300,000 … in due time. But, the point is to look at the company atthe time of the investment, which makes the math very simple: $100,000 + $200,000 = $300,000. Another mistake entrepreneurs often make is to use the pre-money valuation to determinethe ownership percentages. Allow me to use different hypothetical numbers than above forthis explanation. With these new numbers, the entrepreneur retains majority ownership. If acompany’s pre-money valuation is $1,000,000 and an investor puts in $500,000 cash, then howmuch does the investor own? Many people would say “half” because $500,000 is one-half of$1,000,000. The investor put in half as much value as the entrepreneur. This is wrong. Theinvestor will only own one-third of the company because the formula is Pre-money + Investment= Post-money. The post-money (i.e. the value after the money comes in) is $1,500,000 and$500,000 is only one-third of that. The investor would own 33%, not 50%. Another way tolook at it is Yours + Mine = Ours. We need to know much “you” and “I” own of “our” collectivecompany.
Negotiations with investors
There are dozens of terms you could haggle over when dealing with investors. Liquidationpreference, conversion rights, anti-dilution protections, etc. In many cases, no single item is