Investment/financing deal term sheets and agreements contain a number of commercial and operative terms, which sound technical and complicated. While many of these are standard terms, it is essential that parties have at least a working understanding of these terms to enable them to negotiate the deal, and have an appreciation of what they're signing up to. Over the next few months we would be putting out short articles at regular intervals explaining some of the common deal terms. Without further ado, let us go to the topic at hand.
Pre-Money & Post-Money Valuation:
- "Pre-Money Valuation" is the valuation of the company at which investment is made.
- "Post-Money Valuation" = Pre-Money Valuation + amount invested in the round.
Investor's ownership percentage is determined based on Post-Money Valuation. (The pre-investment cap table gets 'diluted' by Investor's ownership percentage). The price per share at which the company issues shares to the investor is as follows:
Pre-Money Valuation X total number of shares (including shares in the ESOP pool) on the cap table before the investment is made.
The product of share price and the total number of shares on the cap table after the investment gives the Post-Money Valuation.
ESOP Pool Pre-Money or Post-Money?
The investor usually asks that ESOP pool be created (or increased) Pre-Money. That means, the dilution due to the ESOP pool creation or increase should be entirely taken by the existing shareholders. The share price at which the company issues shares to the investor decreases if ESOP pool is created/increased Pre-Money (see the concept of share price calculation explained above).
On the other hand, if ESOP pool is created/increased Post-Money, investor also gets diluted. Here, the dilution, and the decrease of value taken by the founders and any other pre-existing shareholders (i.e., folks who already owned shares before the investor came in) would be lower, compared to creation/increase of ESOPs on the Pre-Money cap table. 'Decrease of value' can be ascertained by looking at the price per share post ESOP creation/increase.
Investors insist on ESOP creation/increase Pre-Money as the need to expand the cap table (in this case, to hire talent) is foreseeable, or even a pre-existing condition of the company.
Useful tip: Increase of shares on the cap table due to increase of ESOP pool doesn't increase the valuation of the company, unlike an increase of shares resulting from an investment.
Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.
Originally published 17 October 2019
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