Raising money is a complicated multistage process that successful entrepreneurs master from first contact (or earlier) right through to cash in the bank. Establishing a valuation is one of the most important steps along the way. Aim too high and investors will look the other way. Aim too low and you’ll leave money on the table, or even worse, you’ll lose investors who think you lack ambition.
One odd fact about the fundraising process is the more you raise, the higher the valuation. This illogical link occurs because investors want to ensure founders retain enough equity to keep them motivated, even after multiple financing rounds. As a result, the convention is that early rounds of investment typically result in ~20% dilution. So, given the dilution is fixed, if the round size goes up, increasing the valuation is the only way to square the circle.
The first thing to do is to work out how much money you want to raise. Make sure you raise enough to achieve your next valuation milestone with time left to find the next round. For very early-stage companies, that’s usually 12-18 months. For a longer answer, see this post by Mark Suster.
The next thing is to put yourself inside the mind of your target VC. If you can second-guess how they value your business, you can ensure the amount you are raising is consistent with the 10-25% dilution guideline and structure your pitch accordingly. As I wrote back in 2011, there are three ways VCs value startups:
1. The right way for a VC to value a company
To value a business, VCs estimate what it would fetch on a successful sale, then divide the figure by the return appropriate for the risk. So, if the planned exit is £100m and the investor is targeting a return of 10x then the post-money value today would be £10m. If the investment is £2m, the pre-money would be £8m (£10m minus £2m) and the investor would get a 20% stake. In practice it is more complicated, because adjustments need to be made for liquidation preference and dilution from further rounds.
A number of data points will be taken into consideration when forecasting the exit value:
- Likely turnover and profits (losses) of the target company at the point of exit
- Revenue and profit multiples that acquirers trade at
- Multiples that other similar businesses have been acquired at
- Track record of potential acquirers in making high-value acquisitions
- Strategic importance of the target company to potential acquirers
After the projected exit value, the next driver of the target valuation is the target return. There is little science here. Most VCs think of the required target return in three bands: low risk (3x return), medium (5x) and high (10x). At the early stages at which Forward invests, all companies are high risk.
2. Rule of thumb
As noted above, one enduring rule of thumb is that an investment round should get 10-25% of a company. When they know how much a company plans to raise, investors multiply the amount by four to 10 to gauge the post-money valuation range.
Do you see how circular this is? In a perfect market, valuation would be independent of the amount being raised. But in the real world, the two are interdependent. Entrepreneurs must balance cash requirements of their business and valuation needs of investors.
3. Market forces
VCs figure out valuations using the methodology above, then moving them up or down depending on market conditions and the competition for an individual deal.
If you’re successful in making your deal competitive, VCs will often revisit their analysis to see if they can justify a higher valuation. The most common route to do this is look again at the exit valuation and build a stronger case for a larger exit.
There’s no mention of Discounted Cashflow (DCF) analysis here. DCF requires projecting cash flows many years into the future then estimating a ‘terminal value’. In the case of startups, this is a presumed trade sale or IPO. The prospects of startups are very uncertain and the assumptions required can only be guesswork. No matter how sophisticated the model, if the assumptions can’t be trusted, you end up with a garbage-in/garbage-out problem.
Having developed a view on your business’s valuation, you need to test the market. The best way is to talk with investors. You should do this two to three months before starting your fundraising process. You can use such meetings to determine interest in your company and prioritise your list of investor targets.
It’s also helpful to present investors with a wide valuation range. Don’t ask directly about the valuation. Instead, focus on the amount being raised and the target dilution. And remember that small ranges of raise, size and dilution amount to big valuation ranges. For example, imagine you’re thinking of raising £2m-2.5m for 15-20% dilution. That’s equivalent to you thinking of raising £8-14.1m pre-money – and it sounds more credible because the ranges are tighter.
When you present the valuation range, look for body-language clues as well as the actual reply. Remember that most investors will be wary of talking down the valuation to give themselves the best chance of winning the deal. And the investor probably hasn’t worked out how much they like your company, which makes it hard to know how high to push the valuation. One way round this obstacle is to pose the valuation question hypothetically. “If you made us one of your investments, does this range feel right?”, and “Which end would you be at?” are both safe bets. You won’t get an answer from everyone, so be prepared to ask around.
Once you have investor feedback, you’re ready to decide how much to raise and how to approach the valuation issue in the fundraising process. The big question is whether to put forward a valuation or ask your investor to price the round. There is no right answer. Here are a few of the issues to consider:
- If you’re raising from experienced investors, ask them to price the round. You could give them an indicative range, but if they go first you have a better chance of reaching their best price.
- When raising from angels it’s best to tell them the valuation of the round. They are often less experienced and will have less-recent transaction data. They don’t have much time to consider valuations, and don’t want the responsibility of setting a valuation other angels have to follow.
- If you want to close quickly, getting a number out there early will help
- When a deal is hot, it’s hard for investors to know how high to push the valuation. Giving them a number can help nudge them higher.
Finally, remember that the valuation is a combination of headline pre-money, preference structure, and increase in the pre-money option pool. At the early stage, don’t get seduced by investors who offer a big headline price then claw it back via structure or the option pool.