How do VCs determine an early-stage startup’s valuation?

QUESTION:

It seems like a bit of voodoo to me. I just don’t understand how VCs determine an early-stage startup’s valuation?

ANSWER:

Nathan Beckord

by Nathan Beckord at VentureArchetypes

Startup valuation is definitely an art, but there is some science to it, too.

First off, a little math– most VC funds have specific equity ownership percents they expect to receive, given the stage of the deal. For example, at the Series A round, many VCs target owning 25-30% of the company post-funding. Below this, it’s often not worth their time and effort, given the economics of large funds (and the limited bandwidth of each partner).

So, given the formula:

Ownership % = Amount Raised / (Pre-Money Valuation + Amount Raised)

You can see that if we know we’re raising $3M, and VCs expect to own 30% post-funding, the only missing variable is the pre-money valuation. Solve for it, and we have what’s called a “$7M Pre”.

So now the questions become: can you justify raising that amount of money, and is what you’ve built currently worth $7M? Here’s where the “art” part of valuation comes in, and it becomes a function of how well you do two main things:

A) Pitch a good story– one that gets people excited to get involved; and,
B) Use that pitch get multiple investors interested.

Simply put, your goal is to get some heat on a deal, and to generate leverage so you can get the valuation you are seeking. Another way to put this: if you have only one interested investor, you take what they offer (or you walk); if you have multiple interested investors, you can start to set terms (including valuation). (Bonus points if you can point to other, comparable companies and their valuations to justify what you’re seeking.)

Valuation is a really interesting topic to me, especially at the startup stage. If you’re interested, I’ve written a very long post on it here (including a quick-and-dirty valuation table by stage): http://bit.ly/5w3m1Z

And more recently, I attempted to dissect what drives the occasionally-huge valuations we see when “deals go wild” that post is here: http://bit.ly/gNDQov

Enjoy, Nathan