Pre-money value is a metric used by investors that tells them the price of their investment without having to know the number of shares outstanding. Pre-money value refers to the pre-investment value of the enterprise that is implied by the per-share price of the stock being offered and the number of shares outstanding. Because it is adjusted for outstanding shares, the metric allows investors to compare prices across different investment opportunities.
If the issuing company has a simple capitalization table, pre-money value is simply the per-share price to be paid by the investor times the number of shares and contingent shares outstanding before the investment. For example, if a company is offering preferred stock for $0.50 per share, and there are 10 million shares outstanding, the pre-money valuation is $5 million dollars. A company that is offering shares for $1.00 and has 5 million shares outstanding also has a pre-money valuation of $5 million.
As with capitalization tables, pre-money value can be calculated based on outstanding shares only, or on “fully-diluted” shares, meaning that contingent equity such as stock options, warrants, and convertible notes are included in the calculation. Investors will expect pre-money valuation to be based on a fully-diluted cap table, and that is how you should always calculate the metric unless there are special reasons for not doing it that way. A fully-diluted pre-money valuation will be higher (because the share price is multiplied by more shares). Intuitively this makes sense because if an investor can be diluted by contingent equity, they will essentially have to pay more (buy more shares) to achieve the same percentage ownership of the company.
Above, I said that for simple cases the pre-money valuation can be calculated by multiplying the share price times outstanding shares. The pre-money value metric has less explanatory value if the company is offering warrants in conjunction with the stock. To see why, look at the more complete formula for pre-money valuation:
Post Money Valuation = new investment * total post investment shares/shares issued to new investor
Pre Money Valuation = Post Money Valuation – new investment
Dividing new investment by the number of shares issued to the new investor equals the per-share offering price. So doing a little algebra, you can see that, with a simple capitalization table, the above formulas reduce to:
Post Money Valuation = offering price * total post investment shares
Pre Money Valuation = offering price * total post investment shares
But the formula is not so simply reduced if warrants are offered because the warrants have an exercise price. Should the exercise price be considered part of the new investment? It is not paid at the time the investment is made, but it will be if the warrants are ever exercised, and the exercise price will then benefit all other shareholders and be shared if the company is being sold or otherwise liquidated. I have seen it done three different ways:
- First method: The warrants are completely excluded from the calculation – it is not usually done this way, because the warrants will be included in the fully-diluted capitalization table.
- Second Method: the exercise price is ignored but the number of warrant shares is included with post-investment shares – this is the way I see it done most often, but significantly understates the pre-money valuation in my view.
- Third Method: the exercise price is included in the new investment and the warrant shares are included in post-money shares – this makes more theoretical sense to me, but an argument can be made that for large exits, the exercise price becomes less significant so that the Second Method is more comparable to pre-money values where there are no warrants.
To get a sense of the difference obtained by using the three different calculation methods, look at this numerical example where 1,000,000 shares are being offered for $1.00 per share, and where each share comes with a warrant for one share with an exercise price of $0.50.
If you want to play with the numbers you can download the spreadsheet here.
As you can see there is a significant difference in the resulting value. Including the warrant shares in the calculation but not including the warrant exercise price yields a significantly lower pre-money valuation. Issuers will obviously like this metric, since a lower pre-money valuation implies investors are getting a better deal. Investors, if they haven’t looked too closely at how pre-money value was calculated, may assume that the exercise price was concluded.
So which valuation method is correct? None are necessarily correct or incorrect. They are just metrics that are useful for evaluation an investment. What is important is that everyone understands how the metric was calculated. To protect themselves from later claims of misrepresentation or securities fraud, issuers should be sure to clearly state which method they used in calculating pre-money valuation.
One take away from tall of this is don’t offer shares with attached warrants unless there is a good reason to. Usually there is not, and simple is always better.