photo © 2010 Mike Hammerton | more info (via: Wylio)In the world of startup financing, the term “pre-money valuation” is used to describe the value of your company prior to a financing. The pre-money valuation is used to calculate the price per share of the stock that will be sold in the proposed financing (the “Offering Price”) using the following formula: (x) pre-money valuation divided by (y) the company’s share denominator (prior to the financing) equals (z) the Offering Price.

While the pre-money valuation is usually the centerpiece of valuation discussions, it is also important to understand how the “(y)” share denominator figure can play a significant role in ultimate dilution of the company’s existing shareholders from the proposed financing. (more after the jump)

The larger the “(y)” share denominator, the lower the “(z)” Offering Price, which results in more shares being issued in the financing and, therefore, greater dilution to the company’s existing shareholders. Conversely, the smaller the “(y)” share denominator, the higher the “(z)” Offering Price, which results in fewer shares being issued in the financing and, therefore, less dilution to the company’s existing shareholders.

There are at least four ways of calculating the “(y)” share denominator, ranging from the smallest number of shares included in the denominator to the largest, as follows:

• Method (1): outstanding stock;
• Method (2): outstanding stock, outstanding warrants and outstanding options;
• Method (3): outstanding stock, outstanding warrants and the entire option pool (both outstanding and available for future grant); and
• Method (4): outstanding stock, outstanding warrants, the entire option pool (both outstanding and available for future grant) and any proposed increase to the size of the stock option pool (as often required by investors to make sure the company has sufficient options available for future grant).

Below is a hypothetical involving a proposed $1 million Series A financing of startup ABC, Inc. In all four scenarios, ABC, Inc. will raise $1 million on a pre-money valuation of $2 million. The only variable changed is the “(y)” share denominator, and as you will see, the resulting dilution to existing shareholders as a result of the financing varies significantly.