One of the first things entrepreneurs learn about venture capital speak is the significance and difference between pre-money valuation and post-money valuation. These are the terms that VCs use when talking about how much a company is worth before and after a round of financing. While investors in public companies tend to think of valuation in terms of how much one share of stock costs, VCs tend to think of valuation in terms of what percentage of the total ownership of the company they can buy for how much capital. So, for example, if a VC buys 1/3 of the ownership of Newco for $1.0 million, the “post-money” valuation is 3 * $1 million = $3 million and the “pre-money” valuation is $3 million – $1 million = $2 million. If say $2 million bought ¼ of the company the post would be $8 million and the pre would be $6 million.

Another thing entrepreneurs learn pretty early in the VC courtship ritual is that VCs typically get some form of “convertible preferred stock” in exchange for their capital. In the most general of terms, “Convertible Preferred” is a kind of stock that (i) has some extra rights that make it “better” than common (for example, liquidation and dividend preferences, the ability to prevent Newco from doing certain fundamental things like selling the company, etc.) and (ii) is optionally convertible into common stock by the holder at pretty much any time, and can be automatically converted in some instances (typically in connection with an exit transaction where the company is sold or completes an initial public offering at a sufficiently high price). Most often, the conversion rate is 1 to 1: that is, one share of Convertible Preferred converts in to 1 share of common. (The rate can be more or less than that, and can change over time, but neither of those facts changes the fundamentals of the analysis in this blog.)

Alas, these two concepts – pre/post-money valuation and Convertible Preferred – combine to create what looks like a valuation paradox. Let’s consider our $1 million for 1/3 ownership investment. And just to make the math simple, let’s say that the investor bought 1 million shares of Convertible Preferred for $1 each with a 1 to 1 conversion ratio, and the founders own all 2 million shares of common stock. In this situation, the post money is $3 million, right? And the 1 million preferred shares are worth $1 million, right? (Right in both cases.) So the 2 million shares of common stock must be worth $2 million, right? And each of the 2 million common shares must be worth $1, right?

Actually, in both the later cases, no. The common is not worth $1 share – how could it be worth as much per share as the Convertible Preferred, which can be converted to common at any time and has a bunch of special rights that add more value to it? If not a problem, we seem to have at least a paradox.

What is going on here? How can both the pre/post money valuation formula work AND at the same time the Convertible Preferred and Common stock have different values? Let’s try and hash that out, starting with the difference in value between the Convertible Preferred and the Common stock. As to the Convertible Preferred, the price, when it is purchased by a third party investor in an arms length transaction (in this case $1) is, by definition, the fair market value of the Convertible Preferred. Which means that the value of a Common share, at the same time, must, given that it lacks various valuable features of the Convertible Preferred, be worth something less than $1. How much less? Well, that depends. Since no one – or at least no third party in an arms length transaction is buying any at the time – it depends on what the Board of Directors, in good faith, determines it is as, for example, when it issues an option to buy such shares to an employee at what the Board says is the then fair market value of a Common share of stock.

Ok, at this point we know that a Common share is worth less than a Convertible Preferred share, and that the fair market value of the Common share is what the Board says it is. How should the Board determine the fair market value of a Common share?

In theory, the answer is simple; in practice, not so much. In theory, the board should (and any good board resolution purporting to establish the fair market value of a Common share will) “consider all relevant factors” to conclude that such value is less than the $1 value of the Convertible Preferred and more than $0. In fact, most boards will want to set a low value on the Common (to make equity incentive shares cheaper for employees and others getting shares of options on shares as an incentive to make the company succeed), but not so low as to attract the attention of the IRS, which is anxious to tax people who acquire assets, including stock, for less than it is worth.

In practice, there are some informal rules of thumb that tend to apply to very young and immature companies, and some explicit IRS/SEC rules that come into play for more mature companies. So, for example, a brand new startup like Newco might reasonably conclude that the value of a Common share was 1/5 the value of a Convertible Preferred share – which is to say the Common share has a fair market value of $0.20. No legal opinion is expressed here, but trust me: lots of companies have said as much without incurring the wrath of the IRS.

Ok, let’s go with $0.20. What, then, is the value of all of the stock – which is to say the value of the company? Well, there are 1 million shares of Convertible Preferred worth $1 per share, which is $1 million of value. And there are 2 million shares of Common worth $0.20 per share, which is $400,000 of value. So the total value of all the shares is … $1.4 million. Which is to say less than ½ of the post-money valuation of the company! Houston, we have a problem.

Or do we? Ok, there is a seeming paradox, but is there really a problem? I don’t think so. Because while the fair market value of the common might, at some level, seem like a more or less arbitrary determination of the Board of Directors, in fact it has to be something less than $1 in the example. And if it is anything less than $1 we will arrive at a total value of all equity that is less than the post-money valuation calculated by the VCs (and typically accepted, in normal conversation, at least, by the management/founders of Newco). The problem – perhaps a better word is artifact – is with the pre/post money concept.

And this is it. Buried in the pre/post money calculation is a very important assumption; namely that the VC post-money calculation assumes that the company will have a favorable – e.g. north of $1 per share (and probably at least 3x or more of $1 per share) – exit price when the company is sold or goes public. In which case all of the Convertible Preferred will convert into Common – and suddenly the assumption that they are worth the same amount … works.

It’s not elegant. It’s more than a little arbitrary and capricious. But it (more or less) works.