Valuation, or the price an investor is willing to pay for shares in your company, is obviously an important issue. So much so that I was recently listening to the Twenty Minute VC interview with Manu Kumar and he said that he has walked away from many seed deals because of the issue of valuation.
Entrepreneurs have I worked with or had the pleasure of interacting with have often focused a fair amount of energy on this. That does make a fair amount of sense sometimes. Obviously a higher valuation and lower percentage exchanged is favorable but the subtle complexities of cap tables and share pricing make this issue a little confusing at times. The price per share cannot be looked at in isolation and is meaningless in and of itself.
There will be trade offs in terms of pricing and the other rights and preferences You’ll also want to pay special attention to whether or not the Stock Option Pool for future employees is included in the “pre-money” price of your company (the value before the investor put their capital in) or is established “post-money.” Pre-money will be more dilutive to the founders (you bear 100% of the dilutive cost of the option pool), where post-money reflects a “sharing” of the dilutive cost with your new investors.
A secondary consideration around valuation is how the pricing of this round will affect your next capital raise. Remember, raising capital is a journey you are likely multiple times during the life of your startup. A valuation that is extraordinarily high can become problematic when you raise your next round if your valuation is ahead of your business fundamentals. If this is the case, you confront the very real possibility of a “down round” as investors seek to re-set the company valuation. Earlier investors will be protected, to a certain extent by “anti-dilution” provisions, whereas you, the entrepreneur, has no such protection.
The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.
In case it is not evident at this point, the secret lies in the fact that there is no formula for this, certainly not a magic one. If there was I would monetize it, after all, I run a valuation firm. The best and most simple way to come up with a valuation for your startup is as follows in my opinion:
The truth is that at the early stage this not where you want to spend your time. It is silly to spend a lot of time going back and forth when in reality the statistics of success are stacked against you. Meaning it is pointless to argue about whether your startup that most likely may fail is worth $6.0M pre instead of the $3.5M suggested by an investor. You will know more once you actually start to refine your product, satisfy customers, and possibly make it to raising a Series A, at which time the markets may be incredibly different in either direction.
Focus on your product and business. Be humble and remain coachable. Always do your best. Don’t take anything personally. Trust that the rest will take care of itself. Do all this and I promise you will be pleasantly surprised.