Valuations in venture-backed companies seem to be a mystery to most. Even in the past 18 months, when it was close to impossible to raise money, we’ve seen valuations in early stage companies that caused a lot of head scratching (Square, Foursquare, Groupon, etc).
It begs the question of where these valuations come from. B-school students are trained to believe that valuations are driven by the present value of future cash flows, which is a f(cash flow, growth, risk, and capital structure).
But how does this hold when there are no cash flows (in fact, when there is no business model)?
The answer is that VC rounds are priced by the market — by supply and demand.
I once met an experienced VC who admitted to me that he didn’t actually know how to do a DCF. But he did know where a deal would likely close at based on pattern recognition.
Ultimately, the right way to think about VC valuation is not a finance exercise but a negotiations one.
On the investor side, the goal is to acquire as large a position in the company and exert as much control as possible while keeping the entrepreneur sufficiently motivated. On the entrepreneur side, the goal is to maintain a much ownership and control as possible while bringing in a helpful and motivated investor. The bounds between sufficient entrepreneur motivation and the potential to create an attractive return to an investor is a very wide ZOPA (Zone of Possible Agreement). Where the deal closes is a function of the relative bargaining power of the constituents. In other words, are there many other investors clamoring to invest in the company (rarely)? Do the Investors have lots of options for where to put their capital (often). To steal another negotiations term – it comes down to having a good BATNA (Best Alternative to a Negotiated Agreement).
Remember also that it’s not only about valuation, but a lot of other terms that have value. Liquidation preference, option pool, founder liquidity, BOD seats, etc. There are a lot of posts out there that describe some of the levers Investors use to make up for higher valuations. Entrepreneurs should definitely read them.
Rob Go is a former senior associate for Spark Capital. Now he’s an entrepreneur working on a secret project. This post was originally published on his personal blog and is re-published here with permission.
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