Back to Basics- Valuations, Option Pools and What You Need to Know Before Raising Capital

0:00 All right, I am still surprised at how many entrepreneurs are confused about pre-money valuation, post-money valuation, option pool, and how it all works during a financing.

0:09 So I'm going to try to make this clear for you. In order to do so, let's go to the whiteboard.

0:14 So, first is, let's take a simple company. Let's assume that an investor offers you and your founders a million dollar investment on a four million dollar pre-money valuation.

0:26 What that means is your company is worth $4 million.

0:31 We're going to add a million dollars of new capital.

0:33 So the total after the financing will be worth five.

0:36 I'm going to represent this on the vertical axis.

0:38 This is the stuff or the stock that you guys own, the founders.

0:44 And to make it simple, I'm going to say that you own a million shares just to make the math easy.

0:50 Now we said we're going to add a million dollars to this at a four million dollar

0:56 pre-money valuation. So what does that mean? It means we have to figure out how

1:01 much each share of stock is worth. The math is actually quite simple. If it's,

1:05 if this is worth four million dollars, each share of stock is worth exactly four

1:09 dollars. Unfortunately, it's not quite that simple. You see, because the option

1:15 pool that has to get added here which should equal 10 of the post-money valuation or roughly 500

1:27 000 worth of stock because it'll be a five million dollar post gets added to the pre-money

1:34 entrepreneurs don't always like that they're like wait why does it get added to the pre-money

1:38 i thought my stuff was worth four million now you're telling me that my stuff plus the options

1:43 is really what's worth $4 million.

1:46 And it's just really a matter of convention.

1:48 It's sort of like in the U.S. when you see the price on an item in a store, you know

1:53 that you're going to have to pay tax on top of that.

1:56 It's not the full price.

1:58 In Europe when you see price in a store, you know that that is the full price, that they're

2:02 going to deduct, they're going to take the tax out of what you pay, and they only keep

2:07 the net.

2:08 So in one case the tax gets added before, in one case it gets added after.

2:12 In this case with financing, options get added before the pre-money valuation.

2:18 And we have to add enough options such that once we add the new preferred stock,

2:27 that the options represent 10%.

2:30 So there's a little bit of funky math that has to go on here.

2:34 You ready?

2:34 So if this is going to be worth $1 million, we have to figure out how many options we add to get the stack such that we end up with 10% in the end.

2:48 You can do this with an Excel spreadsheet.

2:50 I've solved it ahead of time.

2:51 And so I can tell you that the option pool ends up being about 143,000 shares because the preferred ends up being 285,000 shares.

3:05 And when you add all of these together, it ends up being about 1.4 million shares.

3:14 Now, where are you?

3:18 Well, you see, the founders end up owning about 70% of the business, $1 million out of 1.4.

3:27 The option pool ends up being 10% of the business because it's 143 out of 1.4.

3:35 And the preferred, which is at $285, ends up owning 20% of the business.

3:42 post-money valuation is $5 million.

3:44 dollars. By the way, the price per share, dollars per share, if you do the math, is $3.51. That's

3:54 because if you take $3.51 times $1.4 million, you end up with the $5 million post-money. Hopefully

4:03 that makes sense. And it backs out. If you think about what 70% of the business is going to be

4:07 worth, 70% of the business should be worth about $3.5 million, 1 million shares times 3.51.

4:14 Gets you your three and a half million.

4:16 So hopefully you guys now understand

4:19 what pre-money valuation includes the option pool,

4:25 post-money valuation includes the new capital,

4:29 and you can see how the entire stack works.

4:33 I hope this is helpful.