The question of valuation is intimidating for many early-stage startup founders. As a young company with a short history and little to no revenue, there simply isn’t a formula capable of producing a neat round number that objectively represents the value of your business. Valuation, then, becomes the art of making a deal, not the science of building a spreadsheet.
Many factors play into a valuation negotiation with a VC—your business fundamentals, while important, are among the many. The market landscape, the VC’s incentives, and the strength of your network can all factor into the discussion as much, if not more so, than business economics.
For a valuation, the market landscape, the VC’s incentives, and the strength of your network can all factor into the discussion as much, if not more so, than business economics.
1) Understand The Market Landscape
Your valuation can easily be impacted by factors outside of your control. Like many seasoned VCs, George Bischof of Meritech Capital Partners is predicting a slowdown in the market and a drop in venture investing levels due to the Covid-19 crisis. Traditional supply and demand economics exist in the fundraising ecosystem, too—if there are more sources of capital for startups in the market, you’ll have more leverage in the valuation discussion. If there’s less capital in the market, the VC will be the one with more leverage.
Your industry’s market factors also matter in a discussion about valuation. If your business is in a trendy space with growing demand, you’ll be able to command a premium on your valuation. The flip side is also true—if your business is in a space that has seen some headwinds, VCs will have more bargaining power. Businesses in markets with scalable unit economics and low overhead, such as enterprise software, can generally command higher valuations, as can those in very large markets and markets with high growth potential.
2) Understand The VC Perspective
In any negotiation, it’s always important to understand the underlying factors motivating those on the other side of the table. VCs lean heavily on a few top performers to produce the bulk of their fund’s returns; this is known as the Pareto Principle, or the 80/20 rule. With this in mind, be aware that VCs will only invest in businesses that they think have the potential to grow quickly and produce 10-20x returns on the capital invested. “When you take angel and venture capital, there is an expectation that growth will be exponential,” says Rachel Renock, Co-Founder and CEO of Wethos. “If that’s not your vision, use another type of funding.” Selling your big vision and convincing the VC that you have “unicorn potential” will go a long way at the negotiating table.
VCs will only invest in businesses that they think have the potential to grow quickly and produce 10-20x returns on the capital invested.
Another critical component of the investor psyche is FOMO, or Fear of Missing Out. Investors often syndicate, or participate in the same deals, as each other, so getting a solid, well-connected VC to lead your round helps you set a high valuation and can also bring more money to the table. VCs make a name for themselves not only by investing in the right businesses, but also by getting in at the right time—“late enough that the pattern is recognizable, but early enough that the market has not yet recognized it,” according to Ha Duong, Principal at Cambrial Capital. No VC wants to miss out on the next big thing, so the better you are at convincing them that’s you, the higher the price they’ll be willing to pay.
3) Use Your Professional and Personal Networks
In fundraising, as in many other areas of the business world, your network is key. The stronger your relationship with the VC sitting across the table, the better your negotiation will go. You’re much more likely to be at the top of a VC’s priority list if you’ve been introduced to them by someone they trust, such as another VC they respect or a founder of one of their current portfolio companies. According to Sonya Brown, General Partner at Norwest Venture Partners, now is an especially inopportune time for cold calls. “If you have a prior relationship or met a firm before in person, that’s going to significantly increase your odds in today’s climate,” she writes.
The stronger your relationship with the VC sitting across the table, the better your negotiation will go.
Although not having a pedigree from a top university or leading tech company can make this harder, there are creative ways to expand your network. Attend events and participate in pitch competitions to grow your brand—try to target ones that VCs you’re trying to get in front of plan to attend. If you aren’t a fit for a VC’s thesis, ask them if they can introduce you to others that might make more sense. If you must send a cold email or LinkedIn message, carefully research and personalize it first—nobody likes receiving spam. Most of all, VCs want to invest in founders they like and feel they can trust; be honest, be authentic, and be yourself.
For an early-stage startup, no easy answer exists to the question of valuation. But with your investor’s interests in mind, a solid business to back you up, and some tried-and-true negotiating tactics, you’ll be able to demand, and receive, what your company is worth.