Pre-money valuation = post-money valuation − additional investmentPre-money valuation is an important company value because it serves as a basis for the negotiation of the share of equity given in exchange of the new funds invested. For instance, imagine a start-up company whose entrepreneurs initially invested $100,000, represented by 1000 shares of common equity with a par value of $100.
The venture capitalist agrees to invest $750,000 in exchange of 60% of the capital of the company, which is valued at $1,250,000. This corresponds to a number of shares equal to 1500 and a unit share price of $500.
The pre-money value of the company is $1,250,000 − $750,000 = $500,000. the difference with the initial investment of the entrepreneur is $500,000 − $100,000 = $400,000, which corresponds to the net present value of the company that returns to the entrepreneur.
The ability to extract a high pre-money valuation from the negotiation indicates the bargaining power of the entrepreneur relative to the venture capitalist. Gompers and Lerner (2000) have shown that the higher the competition on the capital market, the higher this bargaining power and so the higher the pre-money valuations.