The prerequisite for business between two parties is that both parties are of the opinion that they will benefit from the transaction. Therefore if a party estimates that he will not benefit from a transaction, he will not complete that transaction.
An entrepreneur seeking an investment is therefore of the opinion that the value created by the investment justifies the dilution of the entrepreneur’s shares. The investor is of the opinion that the value created is sufficient to justify an acceptable return considering the risk involved.
How the added value of the investment is divided is generally unclear when an investor invests in a startup company. The valuation of a startup is derived from a “Pre-money” valuation or the value of the company before the investment. The investment is then added to the “Pre-money” valuation which then becomes the “Post-money” value of the company or the value after the investment as the funds invested are of value in and of themselves.
Several valuation methods are available when it comes to establishing a Pre-money valuation. It is common that the valuation methods are based on the operations plan of the company at least partially. Basing the valuation of a startup on its operations plan brings forth the question whether the operations plan should be based on the assumption that funds from investors are available or not. The difference between the two is substantial especially when it comes to young startup companies where the influx of funds can be the foundation for ongoing operations.
The value of a startup with limited funding, strong patents, and an innovative product is not accurately estimated with an operations plan that doesn’t include the funds from investors in the operations plan. It can also be said that an entrepreneur who includes the funds from investors in the operations plan which the Pre-money valuation is based on and also counts the worth of the funds is counting the value of the funds twice in the Post-money valuation of the company.
It’s important for entrepreneurs and startup investors to realize how the value created by the investment is split between them when the investment terms are negotiated to ensure an ideal result for both parties. The goal of an operations plan is to paint an accurate picture of the future operations of the company, therefore it’s normal that the plan includes operations possible with the funds from investors. If that is done however it’s reasonable that the entrepreneur gives the investor a discount on the pre-money valuation so the value provided by the investment is split in a precise way between the entrepreneur and the investor.