I regularly get questions concerning how venture capitalists value companies. In fact, there seems to be an increase in the frequency of this question to me personally and through AskTheVC.
It’s not an exact science. On top of that, there isn’t a broad enough market to come anywhere near a public pricing mechanism. (Insert joke about current public market chaos here). VCs typically take into account many factors when deciding how to value a potential investment. You’ll note that few of them are quantifiable into hard numbers and at the end of the day, the VC and company must agree on an exact number in order to get a deal done. So what are some of the factors? In no particular order, I present the following:
1. How mature the company is
What stage is the company? Early? Late? Pre or post product release? Customers? Pre or Post Revenue? Other major milestones? Hopefully it’s clear that the later stage company (if all goes well), the higher the valuation.
2. How much competition there is with other potential funding sources
More is better. If I feel like I’m competing with other VC term sheets, then the valuation will likely be higher. I would offer caution to not overplay this card unless you truly have another interested party. I’ve seen this situation a number of times where the company overplays its hand and doesn’t get their fundraising done and loses face in the process.
3. Quality of the management team
With a great management team, risk is taken out of the equation. In fact, many VCs believe (me included) that even the best idea fails without an excellent team. The more this quality team is built out before financing, the higher potential valuation you might get.
4. How the valuation plays into a particular VC’s investment thesis
If a VC is an early-stage investor, they’ll be used to lower valuations than someone who invests in later stage deals. This bias will have a large effect on the process. I’ve seen companies that have received term sheets from both types of investors at the same time with wildly different prices.
5. How much the VC thinks the company in particular wants that VC
VCs bring much more to the table than money (hopefully). If a company wants a particular VC to fund their company (either because of domain-specific knowledge, prestige, nice offices, etc.) the price for that particular VC may be lower than others.
6. Numbers, numbers, numbers
Yes, the numbers matter too. Whether it is past performance or predictions of the future, these all play in. Revenue, EBITDA, headcount, etc. all factor highly into the process. That being said (at least for early-stage companies) don’t believe everything your MBA professor told you about DCF and other financial analysis. Especially at the early stage, the only thing that I know about your financials is that they are very wrong. So the financials have limited applicability to hard number crunching but are very telling of how the management is thinking about their business.
7. How big the market is
This one is pretty self explanatory. Bigger equals better for valuation.
8. Potential acquirers
Again, this should be easy to understand. If there are many natural acquirers for your company, this only helps in the valuation discussions.
Valuations received by your competitors can potentially make a case for you receiving a similar valuation or at least have a small "market" to compare your company performance to. This argument is of different importance depending on who your VC is. Some care a lot about competitive metrics and some don’t value them at all.
10. Current economic climate
Bad climates normally lower valuations. It seems to effect later stage fundraising valuations more than early-stage transactions.
11. Previous deals
A particular VC’s experiences and biases will have a large effect on valuations they will present you. Part of a VC’s job is to be good at pattern recognition.
There are other things as well, including the tried and true "I know it when I see it" analogy. Part of all of these exercises are truly black box.
Please note that I cannot give specific advice to folks on how much their company may or may not be worth. I only know one thing about attempting this exercise – I would be wrong. And you would not be happy with me.
It takes our group many meetings, much diligence and market analysis in order for us to arrive at the valuations we offer potential portfolio companies and even this is not an exact science. For me to attempt this exercise for a company that I am not deeply involved with would be futile.
At the end of the day, it’s all about getting a transaction completed and whatever that number ends up being, is a rough approximation of what the company might actually be worth at that point in time.
Or maybe it’s completely irrelevant. But at least you got funded. Good luck out there.
(I feel like I could write an entire series of posts on the subject, but I think that would inject too much false precision to the discussion. Again, the majority of the factors are not easily quantifiable If you just can’t help yourself and need to see numbers, check out the Dow Jones report to see some GENERAL guidelines. You can buy the whole report here.)