This week's tip: how to value your company during a funding round.

One of the challenges founders face during the fund-raising process is that they are seeking investment from individuals with "asymmetric information." Investors are evaluating numerous deals and have a well-developed understanding of how the market values these deals, thanks to all of the companies they see at the same time. As an founder, this can feel daunting, similar to buying a car where the dealer knows the price of every make and model, while you are left guessing.

So how do you know what your company is actually valued for? How do you negotiate with an investor to decide that number?

In this post, I will discuss how to approach the topic of valuation in a startup and provide insights into what potential investors might be considering before they decide to value your company.

1. What was the valuation of your previous round?

It is not uncommon for a VC to inquire about the amount of capital you have raised and the post-money valuation of your most recent round. Some founders may feel uncomfortable with this, as if they are sharing confidential information that could potentially harm them. However, these are simple questions and the answers will not affect your ultimate success. In reality, most VCs have access to databases like Pitchbook that already contain this information.

So why does a VC ask you?

In the first place they’re looking for “fit” with their firm.

If you’re talking with a typical Seed/A/B round firm they often have ownership targets in the company in which they invest. For example, when we sat in an investment committee at Octopus, we would come out with a range of ownership that we would aim for. This would usually be around 15-25% give or take. So if we were to invest $5million and target around a 20% ownership we would be looking at companies raising in the $15-20 million pre-money range.

If you are raising significantly more than that (and you have already raised a larger round before that) it may just not fit with us. Some funds are more price sensitive than others (I remember losing a lot of deals purely because we were more price sensitive than other funds!).

Another consideration for a VC may be whether your last-round valuation was significantly overpriced. Valuation is subjective, but if a VC believes that your previous round's valuation was too high, they are more likely to politely decline rather than negotiate a lower valuation now. VCs generally dislike "down rounds" and may even have reservations about "flat rounds." There are a few reasons for this. Firstly, VCs prefer not to upset your previous-round VCs as they may need to collaborate with them in future deals. Additionally, VCs are hesitant to become shareholders in a company where other shareholders already have negative sentiments towards them.

Furthermore, a stagnant or declining valuation can create a negative perception of the company's momentum. I recall rejecting a company in 2019 for this very reason, and that company struggled to raise funds solely due to their previous down-round.

This experience influences VCs to be cautious about participating in the next down or flat round. In a market where there are always other promising opportunities to evaluate, why invest in a startup with a negative narrative from the outset?

The question of "how much have you raised?" is typically a VC's way of assessing your capital efficiency with the funds you have raised thus far. If you have raised significant amounts of money but cannot demonstrate substantial progress, it becomes more challenging to justify your past expenditures and whether you can execute properly.

Ultimately, it all comes down to execution. If a company is burning through money without any visible traction, investors will be reluctant to get involved.

2. What expectations do you have about valuation?

One of the most common questions I would ask founders whom I liked was about their expected valuation. I did this for two reasons:

1. To find out if their expectations were within our range
2. To understand the range in order to be prepared during negotiations

Both of these factors are important to a VC as they serve as a precursor to determine their interest.

On your end, it can be a tricky situation, but I would suggest the following:

• In most cases, avoid stating an actual price.
• Inform the VC that you are seeking value-add investors and expecting a valuation within a normal range.
• Shift the conversation by politely asking the VC, "Considering you must have an idea of our general valuation, how do you think the market is currently pricing rounds similar to ours? After all, we only raise funds once every 1-2 years!"

Why shouldn't most founders name a price? Firstly, it is the responsibility of the "buyer" to propose a price, and you don't want to state a valuation that could be lower than what the VC would have offered or too high, causing the VC to back out. Secondly, it is negotiation 101, that the person who gives the information first is the loser. So don't be the loser.

3. Can I make my expected returns?

An investor is always looking for an exit strategy, so they need to believe that they can achieve satisfactory returns upon exiting.

There are a couple of things they consider in this regard:

1. "Will I achieve my target returns if the company exits?"
2. "Can the company reach a sufficiently high exit valuation?"

Think of it this way:

• At the pre-seed/seed stage, investors are looking for approximately a 100x return.
• At the Series A stage, investors are looking for approximately a 10x return.
• At the Series B stage onwards, investors are looking for approximately a 4x return.

At each stage, you need to demonstrate why you have the potential to provide such returns in the future.

Let's consider a seed round where you want to value your company at $10 million (for the sake of simplicity).

For an investor to achieve a 100x return on their investment, you would need to exit for over $1 billion.

Now, how do you reach that $1 billion valuation? Is it through exit multiples?

If it is, let's say the exit multiple for your industry is 10x.

That means you would need to generate $100 million in annual revenue. Is this feasible? What would that look like? Does the investor believe you can accomplish this?

If the investor doubts your ability to reach this revenue target, then a $10 million valuation is too high. If they have confidence in your potential, then it aligns with their expectations.

4. What is the perception of the business and founder?

How you negotiate your valuation depends on the performance of your business and the demand you have from other investors.

If the perception of you is good and the investor thinks you have a great opportunity an investor will be more comfortable of investing into you at a higher valuation. That may be due to a multitude of reasons:

1. Hype around you or your industry (e.g. AI right now!)
2. Momentum and competition in the round
3. Market craziness like it was in 2021
4. Belief in your exit potential
5. FOMO

If the investor thinks you are an amazing founder with an amazing opportunity, their ranges will go out of the window. Some have strong will-power to not do this (we rejected companies many times due to stupidly high valuations), but not all investors will.

They will take the high valuations purely for the chance to invest into greatness.

So how do you value your company?

As you can see from the above this is never an objective measurement.

This comes down to 4 points:

1. How much you are raising
2. What equity is given away
3. What is the perception of the opportunity
4. What could the potential exit of the company look like

Once you have these, its about nuanced negotiation with your investors to decide on the exact number. In the simplest of terms, think of it as how much you are raising and then a 15-30% round dillution. Where you sit in that range depends on how you fundraise and how an investor thinks about you and your company.

You might consider the following approach when asked about your expectations:

• We closed our last round at a post-money valuation of $15 million, after raising $3 million.
• This round took place 18 months ago, and we believe we have made significant progress since then.
• Our goal for this round is to raise between $5-7 million.
• We have a general understanding of how VCs price rounds, and we expect our valuation to be within the normal range of expectations.
• Our primary focus is finding a VC partner who offers the best long-term fit and can help us create the most value. We are not solely focused on securing the highest price, but we do want a fair valuation.
• How do you typically approach valuation for a company at our stage? (this is seeking feedback/testing your response)

By providing these signals without explicitly stating a price, a VC would interpret the following:

• The price for this round needs to be higher than the $15 million valuation of the previous round, which occurred 20 months ago. The founder's statement about making great progress implies an expectation for a higher valuation.
• The founder is seeking to raise $5-7 million and is aware of the typical valuation range for this amount. Assuming a dilution of 20-25%, this suggests a pre-money valuation between $20-28 million ($25-35 million post-money). The founder may aim for a slightly higher valuation, but they are unlikely to accept a lower one.
• The founder has expressed that they are not solely focused on securing the highest price. While the VC understands that entrepreneurs generally seek the highest reasonable price, they believe the founder will not exclusively base their decision on price alone if the offer is in the ballpark of fairness.

When should you name your own valuation?

There are certain types of funding rounds where simply naming a price might be a better option.

1. Angels. Angels very rarely will price a round, even if one may decide to lead. At this point its better to either give a valuation and see if they like it, or focus on doing a SAFE/ASA so you don’t have to price your company until the next round.
2. Strategics (industry investors vs. VCs). For some reason, many strategic investors prefer not to lead rounds and they also avoid naming a price. Providing a price helps them evaluate the deal more effectively. They are often better at making a "yes/no" decision rather than naming a price.
3. Many investors. When you are raising funds from 8-10 new sources instead of just 1-2, sometimes it is easier to simply name the price. Some call this a “party round”. One reason for raising from multiple sources could be that you have not been able to find a strong lead investor for a larger amount, but many sources are willing to contribute smaller amounts. This way you can get multiple people to agree a price and close the round this way.