When a VC decides to invest in a company, it has to decide how much that company is worth in order to determine the percentage of stock it should get in return for the investment.

First, it is necessary to arrive at a pre-money valuation, which is the amount the company is worth before the VC invests any money.

Second, the post-money valuation is determined. This is how much the company is worth after the VC invests the money.

The percentage increase between the pre and post valuations determines how much stock the VC receives. Typically, this will range from 10 – 50% of the company. The original shareholders are diluted in the process i.e. their remaining shares are allocated on a ratio basis.

For example, if an investor makes a R10 million investment into a company in return for 20% of the company’s equity, the implied post-money valuation is R50 million. To calculate the pre-money valuation, the amount of the investment is subtracted from the post-money valuation. In this case, the implied pre-money valuation is R40 million.

As wikipedia says:

(The) need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.