Question:  A Venture Capitalist pays $1 million for 1 million shares of convertible preferred stock laden with special rights and protections (including the right to convert into shares of common stock one-for-one at the VC’s option).  The company also has 2 million shares of common stock outstanding.  What is the pre- and post-money valuation of the company?

If you answered $2 million pre-money and $3 million post-money you can pat yourself on the back.  The investor paid $1 million for one-third ownership, and three times $1 million is $3 million.  Venture Capital 101 stuff.

But wait a minute.  Take another look, and ask yourself this: if the preferred stock is convertible any time into common stock one-for-one; comes with a lot of value-added goodies; and is worth $1.00/share, how much is the common stock worth?  If you answered “something less than $1.00/share” (how much less is good topic for another blog), pat yourself on the back again.

Except, if there are 1 million shares of preferred outstanding worth $1.00/share, and 2 million shares of common outstanding worth something less than $1.00 share, the value off all the stock outstanding is … something less than $3 million – which is to say less than the $3 million post money valuation that we learned about in VC 101.

So we have the venture capital valuation paradox.  How can everyone agree that the post-money valuation is $3 million and at the same time agree that the value of all of the stock of the company is worth something less than $3 million (probably something like $2 million, though again, that is a subject for another blog)?

Okay, let’s cut to the chase.  The “correct” answer, for accounting purposes, in terms of the value of a company owned by its shareholders is the aggregate value of all of the shares of stock outstanding. This, in our example, is something less than $3 million.  That said, both the entrepreneur and the VC in our example will continue to think in terms of a $3 million post money valuation.  Perhaps they are less than accomplished accountants?  Or are they just plain stubborn?  Or is something else going on, something more important (don’t tell this to your CPA) than GAAP (generally accepted accounting principles).

What gives here is the notion that while accountants think in terms of what a deal is actually worth at a specific point in time, in the context of the close of a venture capital financing, entrepreneurs and venture capital investors think in terms of what a deal is worth assuming that it ultimately “works.”   That is, assuming that the company will ultimately achieve an exit at a price significantly higher than the price last paid for the preferred stock.  In this case, all of the preferred stock will convert into common stock – and thus, ultimately, be worth what the common stock is worth, or $1.00 per share as of the closing of the instant financing. This equates to a post-money deal valuation of $3.0 million.

The analysis is not very elegant, and is perhaps even arbitrary.  But that’s the way everyone (everyone but the accountants, at least) keeps score in the venture business.