Of course, higher rates of interest also reflect a higher-risk investment. So, if your opportunity is riskier than other alternatives, you’ll need to offer potential investors a better return to convince them to part with their hard-earned cash.
Alternatively, a fixed amount and number of annual payments, or discounted rate, can be the given element in the formula; thus, the assumed amount of capital to be invested (in other words, the discounted value of the future payments) is then derived, again, as a function of the selected cap rate. As the assumed amount of interest that you’ll pay ‘” cap rate ‘” goes up, the discounted value of the payment stream goes down, and fewer dollars are required on day one to earn the forecast income flows expected by the investor at the higher rate. Put another way, the higher the cap rate, the lower the initial valuation.
Example: In simple terms, an entrepreneur claims her company will be worth $100 million at the end of its fifth year. This valuation is called the company’s terminal value. But how much is that $100 million worth today? Well, if the payoff is as certain as a United States Treasury Bond (that is, with a cap or interest rate of, say, 5 percent) the present (pretax) value is about $78,350,000. If, however, the venture capitalist considers the risk high, then the cap rate may increase to 25 percent. That means when the $100 million is paid on the fifth anniversary, most of it ($67,230,000 to be exact) is represented by assumed interest. The smallish remainder ($32,770,000) is the assumed present value of the principal.
Another couple of expressions commonly tossed around during discussions of valuation are before the money and after the money. These expressions relate to what are simple concepts, but unless you really understand the differences between them, they can trip you up ‘” it happens even to sophisticated analysts. The definitions that follow will help:
- Before the money. The value of a company before it receives a venture capitalists cash investment.
- After the money. The value of a company after it receives a venture capitalists cash investment.
Read through the following scenario to see how a little confusion about before the money and after the money can cause a great deal of trouble.
If a founder values his company at $1 million on day one, then 25 percent of the company is worth $250,000. However, an ambiguity may exist. Suppose the founder and the investors agree on two terms: (1) a $1 million valuation, and (2) a $250,000 equity investment. The founder organizes the corporation, pays a nominal consideration for 1,000 shares and, shortly thereafter, issues the investor 250 shares for $250,000. A disagreement can immediately occur.
The investor may have thought that equity in the company was worth $1,000 per percentage point. In other words, $250,000 gets 250 out of 1,000 shares, not 250 out of 1,250, shares. The founder believed that he was contributing to the enterprise property already worth $1 million. For $250,000, the investor’s share of the resultant enterprise should be 22.5 percent ‘” a bit of a disappointment to an investor who thought she was buying 25 percent of the $1 million company’s shares. The issue boils down to whether the $1 million value agreed upon by the founder and investor was to be assigned to the company prior to or after the investor’s contribution of cash.
The difference between premoney valuation and postmoney valuation ‘” and its affect on ownership ‘” can be made clear through the following example. In the first case, the company has a value of $10,000,000 before the money; in the second case, the company has a value of $10,000,000 after the money.
- If a company has a premoney valuation of $10,000,000 and investor cash is added to the tune of $5,000,000, then the postmoney valuation is $15,000,000 (that is, $10,000,000 + $5,000,000). The investor’s resultant share of the company is therefore $5,000,000 / $15,000,000, or 33.3 percent.
- If a company has a postmoney valuation of $10,000,000 (after the investor kicks in $5,000,000), this means that the investor’s share of the company is therefore $5,000,000 / $10,000,000, or 50 percent.
As you can see, this is quite a swing in the investor’s ownership position, and if the method of valuation ‘” premoney or postmoney ‘” isn’t spelled out clearly in advance of closing the deal, it’s easy to see how misunderstandings can quickly arise.