Excerpted with permission of the publisher, Wiley, from Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, Third Edition by Brad Feld and Jason Mendelson. Copyright (c) 2016 by Brad Feld and Jason Mendelson. All rights reserved. This book is available at all booksellers.
You may be wondering how VCs really value companies. It is not an exact science regardless of the number of spreadsheets involved. VCs typically take into account many factors when deciding how to value a potential investment—some are quantifiable whereas others are completely qualitative. Following are some of the different factors, along with brief explanations of what impacts them.
Stage of the company. Early-stage companies tend to have a valuation range that is determined more by the experience of the entrepreneurs, the amount of money being raised, and the perception of the overall opportunity. As companies mature, the historical financial performance and future financial projections start to impact valuation. In later-stage companies, supply and demand for the financing combined with financial performance dominate, as investors are beginning to look toward an imminent exit event.
Gates Capital Management's Excess Cash Flow (ECF) Value Funds have returned 14.5% net over the past 25 years, and in 2021, the fund manager continued to outperform. Due to an "absence of large mistakes" during the year, coupled with an "attractive environment for corporate events," the group's flagship ECF Value Fund, L.P returned 32.7% last Read More
Competition with other funding sources. The simple time-tested rule for the entrepreneur is “more is better.” When VCs feel that they are competing with other VCs for a deal, price tends to increase. However, a word of caution—don’t overplay competition that doesn’t exist. If you do and get caught, you’ll damage your current negotiating position, potentially lose the existing investor that you have at the table, and, if nothing else, lose all of your leverage in other aspects of the negotiation. Our belief is that you should always negotiate honestly. Over representing your situation rarely ends well.
Experience of the entrepreneurs and leadership team. The more experienced the entrepreneurs, the less risk, and, correspondingly, the higher the valuation.
Size and trendiness of the market. There will be some pricing influence depending on how large, or trendy, the market is that you are playing in.
The VC’s natural entry point. Some VCs are early-stage investors and will invest only at low price points. For example, we know of one well-known early-stage investor who publicly states the intention not to invest at a valuation above $10 million post-money. Later-stage investors tend to be much less focused on a specific price level and care more about the specific status of the company. While VC firms often have stated strategies, it’s often the case that they will diverge from these strategies, especially when markets heat up.
Numbers, numbers, numbers. The numbers matter. Whether it is past performance; predictions of the future; revenue; earnings before interest, taxes, depreciation, and amortization (EBITDA); cash burn; or head count, they each factor into the determination of price. That being said, don’t believe everything your MBA professor told you about DCF (discounted cash flow, for those of you without an MBA), especially for early-stage companies. Remember, the only thing you know for sure about your financial projections at the early stages is that they are wrong.
Current economic climate. Though this is out of the control of the entrepreneur, it weighs heavily on pricing. When the macro economy or stock market is in the dumps, valuations are lower. When the macro economy is growing quickly, valuations go up. Specifically, valuations often expand when there is future optimism forecasted about the macro economy. However, these events are not tightly correlated, especially in the technology sector.
Regardless of an investor’s justification for the valuation they are giving you, recognize that it’s a guess stimulated by multiple factors. While numbers matter more in the later stages, don’t be insulted if your valuation and a VC’s valuation aren’t the same, as each of you is coming from a different perspective. Our best advice to entrepreneurs on maximizing price is to focus on what you can control and get several different VCs interested in your financing.
The Entrepreneur’s Perspective
I encourage entrepreneurs not to take valuation personally. Just because VCs say their take is that your business is worth $6 million, when your take is that your business is worth $10 million, doesn’t mean that they lack appreciation for you as a CEO or your business’s future potential. It means they are negotiating a deal to their advantage, just as you would.
Article by Brad Feld and Jason Mendelson, Authors of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, Third Edition
BRAD FELD has been an early-stage investor and entrepreneur for over twenty-five years. Prior to co-founding Foundry Group—a Boulder, Colorado-based venture capital firm—he co-founded Mobius Venture Capital. Brad also founded Intensity Ventures, a company that helped launch and operate software companies. Prior to this, Brad founded Feld Technologies. He is also a founder of Techstars and has been active with non-profit organizations, including acting as chairperson for the National Center for Women in Technology. For more information, please visit http://feld.com/
JASON MENDELSON has 20 years of experience in the venture industry. Prior to co-founding Foundry Group, Jason was a Managing Director and Chief Administrative officer at Mobius Venture Capital, where he also served as the firm’s general counsel. Besides his experience as a venture investor, Jason has also been a software engineer, startup lawyer, and a co-founder of SRS | Acquiom. He is an adjunct at the University of Colorado Law School where he co-teaches a course on venture capital and entrepreneurship. For more information, please visit http://www.wiley.com/