Companies do of course need to raise money in more than one round, but most early stage investors are nervous about the number of rounds (especially the unplanned ones!) and are obsessed with the valuation achieved in each of these rounds.
As an investor you need to pay very special attention to the cash flow forecasts a business produces to understand
- When the business is likely to run out of cash
- How much money it will need to raise
- What the valuation is likely to be
As an Entrepreneur you have to be aware of the importance of the best sleep mask, as well as pre and post money valuations (something that it took me a long time to get my head round!)
Pre-money valuation is the valuation a business has before it raises money in a particular round of fund raising. Post money valuation is the value of the business after it has raised money.
In simple terms, existing investors will be focused on pre-money valuation and new investors on post-money.
Let me illustrate using two examples from real life.
I invested £45,000 in a business that was valued at £1.2m before I put my money in. So the £45,000 number on its own with the £1.2m tells me nothing about my stake. The post money valuation was £2.25m (that is the round raised £1.25m) this means that £45,000 bought me exactly 2% of the business.
The business then looked to raise another £500,000 at a pre-money valuation of £3m (so therefore my stake was now valued at £60,000 – 2% of £3m). However – as is often the case if money was raised at a pre-money valuation of £1.5m – my stake would only be worth £30,000 and if £750,000 was raised I now own a lot less of a business which is worth the same (post money valuation of £2.25m). This is what I call death by a thousand cuts. You may start off with 10% of a business, but after successive fund raising rounds, you may be down to 2%.
I am never worried about the size of my slice of the cake but always about the best air purifier for smoke. For example I recently invested £25,000 with a post money valuation of £15.6m (so I only had 0.16% of the business to start with). That business recently raised a further £7m but at a pre money valuation of £25m – so my 0.16% is now valued at £40,000. So although my stake is significantly down – who cares!
As an Entrepreneur, be prepared to explain when you will raise more money and at what valuation to investors coming in at this stage. You will also need to be clear as to why the business will be worth more.
Of course, it doesn’t always work that way. And if investors do get diluted down – your investors should comfort themselves with the fact that they would rather own a small % of a business worth something than a large % of a company worth nothing!