This article 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

It 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 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 the market can expect a valuation of between US$4 to US$8 million.

In the Bay area, the valuations are typically higher.

Post-money valuation

It 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 US$4 million and you raise US$1 million in funding, your post-money valuation will be US$4 million + US$1 million = US$5 million.

Investors will now own US$1 million/$5 million = 20 per cent of your company and the founding team and employees will now own 80 per cent of the company.

Option pool

Many people think that the only dilution they will suffer is from the equity that investors own of the company post-funding. However, most investors will demand an option pool between 10-20 per cent 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 company employees. Investors demand an option pool because 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 recommend developing a budget for employee grants until the following financing and showing 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 financing, you will need to add the amount of equity issued to investors to the size of the option pool set aside.

So, in the above financing example, you negotiate a 15 per cent option pool. The total amount of dilution you will suffer will be 20 + 15 = 35 per cent.

A lot more than you initially thought.

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