In this article, I will discuss the concepts around Pre-Money and Post-Money valuations, Option Pools and Dilution as they are all interrelated concepts that affect the dilution that you can expect when you raise money.
Pre-Money valuation is the valuation of your company when you are ready to raise your next round of funding. Your company’s valuation is a function of the strength and completeness of your team, the amount of progress that you have made with your product, patents that your company may possess, size of market opportunity etc. This will be typically negotiated with investors when you go out and seek funding. In Seattle, for example, a strong team that has a product in market can expect a valuation of between $4 to $8 million. In the Bay area, the valuations are typically higher.
Post-Money Valuation is the valuation of the company immediately after you raise funding. To calculate the Post-Money valuation, you add your funding amount to the Pre-Money valuation of the company. So, for example, if your Pre-Money valuation is $4 million and your raise $1 million in funding, your Post-Money valuation will be $4 million + $1 million = $5 million. Investors will now own $1 million/$5 million = 20% of your company and the founding team and employees will now own 80% of the company.
Many people think that the only dilution that they will suffer is from the equity that investors own of the company post funding. However, most investors will demand an Option Pool of between 10% to 20% post money (i.e. after the money has been invested). An Option Pool is the amount of equity that you set aside to grant to future employees of the company. The reason that investors demand a 10 to 20% option pool is that they don’t want to suffer dilution from future option grants to employees. They would rather that you suffer the dilution! This number can, however, be negotiated with investors. I would recommend that you develop a budget for employee grants until the next financing and show why only a certain size option pool is necessary. Note that typically in every financing investors will want to ensure that a certain size option pool is available post money — however, the amount will reduce over time as you will need to grant a lower amount of options to employees as your company gains traction.
To calculate the total amount of Dilution you will suffer from a financing, you will need to add the amount of equity issued to investors to the size of the option pool set aside. So, let’s say in the above financing example, you negotiate a 15% option pool. The total amount of dilution you will suffer will be 20% + 15% = 35%. A lot more than you originally thought!
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