The Dreaded Question of Valuation

Posted on Jul 28, 2009 | 10 comments


coins chartThis is part of my ongoing series, “Pitching a VC” – the entire outline is here

Whenever I sit on panels and discuss the topic of fund raising the topic of how to handle the discussion of valuation (e.g. how much you’re worth) always comes up.

I have very fixed views on this topic although I’ve learned through these discussions that not everybody agrees with me.  Having sat on both sides of the table on many occasions – I’m pretty sure I’m right about this one ;-)  I know that the line of answering below mostly applies to 2009 (e.g. tough fund raising environment) but I think holds more generally.

VC asks the following line of questioning:

Q: What was your last round post-money valuation?

(translation: how expensive was this deal previously?  Do I think they’ll want an up-round, down-round, flat-round?)

Q: When did you raise the money?

(translation: if it was raised in the peak of the market and the price was high then I should be looking for a down round.  If you raised it 1 year ago, what progress have you made that would justify a flat round or an up round)

Q: What are your expectations on valuation? … or … What price are you raising at now?

(translation: based on my views of whether you’re over valued at the last round or not, please help me figure out whether it’s worth spending any more time with you now.  My scarcest resource is my time.  If you or your investors have unrealistic expectations on valuation I don’t want to waste my time trying to talk you down on price.  I’ll just move one.  There’s plenty of other “fairly priced” deals out there.  See here for an article in the NYT on this tension.

So what do you do?  My advice:

1. Be humble. I prefer the following line, “Listen, we know that it is a tough market out there.  We’re realistic about valuations right now.  Obviously we want to get the best valuation we can but we understand the current environment and what the normal valuations are at this time.”

(translation: we want a fair price but we’re not going to be difficult.  Spend more time with us.  Come on, you know you want to!)

2. Don’t name a number. It’s up to a VC to price a deal.  He/She knows that.  They don’t need you to tell them your asking price – they just need to know that you’re not on another planet.  We all had the pre-revenue companies in 2007 trying to get a $40 million pre-money valuation.  It took time for those people to realize that the market had changed so we want to be sure you’re not still one of those.

3. Don’t say, “we’ll let the market determine the price.” That’s everybodies’ favorite line.

(translation to us, “we’re going to run a competition and whoever pays the highest price will get the deal.”  I know that’s not what you mean, it’s just how it sounds in VC speak.

4. Don’t sound desperate. I know it sounds obvious but you’d be surprised that some people really come across this way at times.  I think some people are so beat up and tired of the fund raising process that they already are like dogs with their heads down expecting to be hit.  The number one rule of VC is to make it seem like you have other options and these are likely to yield results.  You’re looking for understated optimism.  Someone else is planning to ask you to the prom.

5. Make it clear that price isn’t the only determinant. My recommended line (and I hope you actually mean it!) is, “We obviously want a fair price but price isn’t the only consideration for us.  We want an investor who does A,B,C.  Ultimately financial success for us isn’t going to come from an additional 5-10% in this round.  It’s going to come from a thoughtful and hard working executive team & board.  We’re looking for somebody that can contribute to this.”

Final note:  Unfortunately many deals from 2005-2008 were overpriced or have investors no longer wishing to invest.  Most teams think the best way to fix all this is by bringing in a new investor.  I know that the easiest way to get concessions out of your existing investors is to have a term sheet so I understand the sentiment.  But I recommend trying your best to clean up your Cap Table before fund raising.  It is hard enough to raise VC in this market with a “clean” deal that is doing reasonably well.  The odds are stacked against you if your deal “has hair on it.”  Go to the barber and clean it up.

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  • Greg

    I’m in the early stages of planning a startup, and I’ve really enjoyed reading through the blog. Very useful stuff to think through even though I’m currently only preparing to pitch my first sweat equity investor, my wife. ;-)

    Off-topic, I’m looking forward to the customer adoption/traction post you mentioned earlier. Also, what was the big pet peeve you alluded to at the end of the demo post?

    Also one more request: At some point, it would be great to get your thoughts on co-founders – finding, selecting, and recruiting them in general, and which co-founder strategies optimizes both general company building and fundraising.

  • marksuster

    I promise to get to the traction slide soon. Maybe next week. re: co-founders – I’ll also cover that. Thank you for posting. re: pet peeve – Someone else had mentioned this to me and I went back and updated it so the response is there now. Sorry. p.s. the old wife can be the hardest sell of them all ;-)

  • Shane

    My question is, how does the VC come up with the initial valuation? Is there a starting point that is typical, and then you put your voodoo on it to come up with a more tailored number, or do you start from scratch on every deal? If there is a starting point (say for specific industries, like consumer web), what is it?

    Thanks again for taking the time,
    Shane

  • Sid

    Would be interesting to hear from you the differences between VC pitching and Angel pitching. What are the differences in approach/strategy that an entrepreneur should be aware of in trying to raise seed money from an Angel

    Sid

  • marksuster

    I’ll try to cover that at a later date. Thanks for the idea.

  • marksuster

    Depends on stage of deal. There are norms for stage and depending on economy. Also depends on last round valuation (sometimes), progress made (or not) since then and how competitive the deal is. But the overarching valuation mechanism is that a VC wants to own between 20-40% of your company, with the norm being 25-33%. So if you can justify raising $2 million your looking at a likely valuation of $4 million pre-money / $6 million post. Obviously just guidelines. The later that stage and the more revenue to judge by the more it would be based on a multiple rather than ownership percentage.

  • Sid

    Mark,

    Is post-money valuation always equal to Pre-money valuation + Amount Invested. Sounds obvious, but was wondering if there’s more to it than that?

    So when multiple funds participate in a particular round, what then is the post-money valuation, does each investor have their own post-money valuation of the business? Or, in a particular round does every participant invest at the same valuation, I’ve always wondered that when seeing multiple investors participating in a round. Thanks!

  • Shane

    Okay, so because the VC or angel has an idea of how much equity they are after, is it better to back into the valuation by calculating how much you are raising, rather than attempting to arbitrarily value a pre-revenue company with young founders? ;)

  • marksuster

    You end up at the same place either way

  • marksuster

    Multiple investors in a round almost always invest at the same price. The main time it’s not the case is when one investor invests early into a “convertible bridge loan” which has a discount or warrants attached to it. Pre-Money + Total Amount Invested = Post Money, yes. However the one big bogey is understanding the impact that options have on the “true” pre-money price, sometimes known as the “option pool shuffle.” Make sure to read this blog post on VentureHacks to understand the whole thing better: http://venturehacks.com/articles/cap-table#more-113