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Deep Dive: How to Talk About Valuation Numbers When Investor Ask?
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TODAYâS DEEP DIVE
How to Talk About Valuation Numbers When Investors Ask?
[This week, I had a call with an investor who has a decade of experience investing in startups globally as a VC (Say Investor-A). We discussed on how founders can approach the topic of valuation when investors ask. So I thought to share some of the key points with you!]
One of the hardest things about the fund-raising process for entrepreneurs is that youâre trying to raise money from people who have âasymmetric information.â
VC firms see thousands of deals and have a refined sense of how the market is valuing deals because they get price signals across all of these deals.
As an entrepreneur, it can feel as intimidating as going to buy a car where the dealer knows the price of every make & model of a car and youâre guessing at how much to pay.
Of course, unlike cars, there is no direct comparison across each startup so these are just some general guidelines to try and even the information field. So, grab your coffee and letâs deep dive into it.
What Expectations Do You Have About Valuation?
It is not uncommon for a VC to ask about your price expectations in this fundraising process. Itâs a legitimate question as the VC is in âprice discoveryâ mode and wants a sense of whether youâre in his or her valuation range.
Itâs a tough dance but, here is what Investor-A suggest:
In most cases donât name an actual price
Your job is to âanchorâ by giving the VC a general range without saying it. Call this âprice signalling.â
Turn the tables on the VC by politely saying, âGiven you must have a sense of our general valuation, how do you feel the market is pricing rounds like ours these days? After all â we only raise once every 1â2 years!â
Why shouldnât most founders just name a price? For starters, itâs the job of the âbuyerâ to name a price and you donât want to name your valuation if it ends up being lower than the VC would have paid or a price too high that the VC simply pulls out of the process.
So Then Why Anchor?
If you donât give signals to a VC of what your general expectations are itâs hard for them to know whether you have realistic expectations relative to their perceived value of you and whether you want to keep them in the process rather than just having them pull out based on what they THINK you might want on valuation.
Any great negotiation starts by anchoring the other partyâs expectations and then testing their reaction.
How you talk about valuation will of course depend on how well your business is performing and how much demand you have from other investors. If I leave out the immediate âup and to the rightâ companies and talk about most others who have made good progress since the last funding but the next round isnât a slam dunk, you might consider something like if asked about your expectations:
We closed our last round at a $17 million post-money valuation and we had raised $3.5 million.
We closed it 20 months ago and we feel like weâve made great progress
Weâre hoping to raise $5â7 million in this round
We know roughly how VCs price rounds and we think weâll likely be within the normal range of expectations
But obviously, weâre going to let the market tell us what the right valuation is. We only raise every 2 years so the market will have a better feel for it than we will
Weâre optimizing for the best long-term fit for a VC and who we think will help us create the most value. Weâre not optimizing for the highest price. But obviously, we want a fair price.
How do you generally think about valuation for a company at our stage? (this is seeking feedback / testing your response)
Here youâve set a bunch of signals without naming your price. What a VC heard was:
The price has to be higher than $17 million, which was the last round. It was 20 months ago and the founder told me she has made great progress (code words for the higher price expected)
She is raising $5â7 million and knows the range of valuations for this amount. If I assume 20â25% dilution that implies a price of between $20â28 million pre-money valuation ($25-$35m post-money). Maybe she wants slightly higher but she certainly wonât want lower.
She has told me sheâs not trying to shop this for the highest price. Iâm not so naive as to completely believe that â every entrepreneur will go for the highest reasonable price with a VC they like so I at least need to put my best foot forward. But if Iâm in the ballpark of fair she wonât game me and push for the highest price as the only part of her decision.
What Was The Post Money On Your Last Round And How Much Capital Have You Raised?
Itâs not uncommon for a VC to ask you how much capital youâve raised and what the post-money valuation was on your last round.
I know that some founders feel uncomfortable with this as though they might somehow be sharing something so confidential that it ultimately hurts you. These are straightforward questions, the answers will have no bearing on your ultimate success and if you want to know the truth most VCs have access to databases like Pitchbook that have all of this information anyway.
So Why Does A VC Ask You?
In the first place, theyâre looking for âfitâ with their firm. If youâre talking with a typical Seed/A/B round firm they often have ownership targets in the company in which they invest. Since they have limited capital and limited time availability they often try to make concentrated investments across companies in which they have the highest conviction.
If a firm typically invests $5 million in its first check and its target is to own 20% or more that means that most of its deals are in the $15â20 million pre-money range. If youâre raising at $40 million pre then you might be out of their strike zone.
Many VCs will have a distribution curve where theyâll do a small number of early-stage deals (say $1.5â3 million invested at a $6â10m pre-money), a larger number of âdown the fairwayâ deals ($4â5 million at a $15â25 million pre) and a few later-stage deals (say $8â10 million at a $30â40 million pre).
Of course, there are smaller funds that are more price sensitive and want to invest earlier and later stage funds with more capital to deploy and write larger checks a higher prices so understanding what is that VCâs ânormâ is important.
A second thing a VC may be trying to determine is whether your last-round valuation was significantly over-priced.
Of course, valuation is in the eye of the beholder but if that VC thinks your last round valuation was way too high then he or she is more likely to politely pass rather than try and talk down your valuation now.
VCs hate âdown roundsâ and many donât even like âflat rounds.â There are some simple reasons. For starters, VCs donât like to piss off a bunch of your previous-round VCs because theyâll likely have to work with them in other deals. They also donât want to become a shareholder in a company where every other shareholder starts by being annoyed with them.
But there is also another very rational reason. If a VC prices a flat or down round it means that management teams are often taking too much dilution. Every VC knows that talented founders or executives who donât own enough of the company or perceive they will have enough upside will eventually start thinking about their next company and are less likely to stick around. So a VC doesnât want to price a deal in which the founder feels aggrieved from day one but takes your money anyway because he or she doesnât have a choice.
Every VC has a story where they did the flat round anyway and the founder said,
âI donât mind! I know our last round valuation was too high.â
In nearly 100% of those cases, the founder expresses his or her frustration a year later (and 2 years later and 4 years later). The memory isnât âBoy, you stepped in at a time when we were having a tough time getting other VCs to see the value in our company â thank you!â it is more likely a softer version of âYou took advantage of us when we had no other options.â
It is this muscle memory that makes the VC want to pass on the next down or flat round. In a market where there is always another great deal to evaluate, why sign up for one where you know there are going to be bruised egos from the get-go?
The âHow much have you raised?â
The question is usually a VC trying to determine whether youâve been capital-efficient with the funds youâve raised to date. If youâve raised large amounts of money and canât show much progress youâve got a tougher time to explain the past than if youâve been frugal and over-achieved.
Investorâs advice to founders on the questions of âHow much did you raise in the last round?â and âWhat was the post-money valuation of your last round?â -
is to start with just the data. If you donât perceive that you have any potential âissuesâ (raised too much, price too high) then this should be a non-event. If you are aware you may have some issues or if you are constantly getting feedback that you may have issues then itâs a smart strategy for you to develop a set of talking points to get in front of the issue when asked.
Are Your Existing Investors Participating In This Round?
This is a delicate dance as well. Each new investor knows that the people who have the MOST asymmetric information on your performance are the previous round investors. They not only know all of your data and how youâre doing relative to the competition, but they also have a good view of how well your management team is performing together and whether youâre a good leader.
On the one hand, a new potential investor will want to know that your existing investors are willing to continue to invest heavily in this round and at the same price that they are paying, on the other hand, they want to invest enough of the round to hit their ownership targets and may not want existing investors to take their full pro-rata investments.
Before raising capital you need to have a conversation with your existing investors to get a sense of what theyâre thinking or at a minimum you better have an intuitive feel for it. Assuming that most of your existing investors are supportive but want a new outside lead, Investor-A recommends answering this something like this:
Our existing investors of course want to participate in this round. They will likely want to do their pro rata investments â some might even want slightly more.
I know that new firms have ownership targets. I feel confident I can meet these. If it becomes sensitive between a new investorâs needs and previous investors â Iâm not going to tell my investors they canât participate but I feel confident I can work with them to keep the sizes of their checks reasonable.
What a VC hears when you say this:
My existing investors are supportive. I will eventually call them anyway to confirm but I can continue my investment assuming they are supportive
In the future, if we raise a larger round this entrepreneur wonât try to screw me by forcing me not to take my pro rata rights because they werenât throwing existing investors under the bus with me
This entrepreneur is sophisticated enough to know that fund-raising is a dance in which I need to meet the needs of both new investors and previous investors. They will work with me so I can get close to my ownership targets.
When SHOULD You Name A Valuation Expectation?
There are some types of rounds where just naming price might be a better option.
Strategics (ie industry investors vs. VCs).
For some reason, many strategic investors donât like to lead rounds and they donât like to name a price. This isnât true of all strategics but it is true for many of them â particularly those who donât have a long history in VC. Having a price helps them to evaluate the deal better. Often theyâre much better at a âyes/noâ decision than naming a price. If you name your valuation you sometimes have to give them a rationale on how similar companies are valued so they can justify their internal case. Knowing that other institutional investors (including your insiders) are paying the same price as them in this round helps.Many Investors.
When you are raising for 8â10 new sources vs. 1â2 sometimes itâs easier just to name price. One reason you might be raising from so many sources is that you havenât found it easy to find a strong lead investor (for say $20 million) but many sources are willing to write you smaller checks (of say $2â3 million each). Many investors can also be in the opposite situation where youâre so successful that everybody wants to invest. In either case, having a price target can help you get momentum.
Turning The Information Tables
Final point. If done in the right way, each VC meeting can be a great opportunity for you to get feedback on how investors are seeing market valuations in the time that youâre raising (valuations change based on the overall funding economy) and also a chance to hear about how the VCs think about your valuation and/or let you know whether or not you have any perceived problems.
You might politely ask questions like:
Does your firm have a target ownership range?
Do you typically like to lead and do you ever follow?
Are there firms you like to co-invest with?
Does our fundraising size sound reasonable to you?
Are there any valuation concerns you might have that we can address now?
Your goal in forming questions is to get signalling back from the VC.
Remember that fund-raising is a two-way process and you have every right to ask questions that help orient you just as a good VC will ask questions of you.
FEATURED TWEET
Slack Founder, Stewart Butterfield On Evaluating Startup Ideas
"Idea generation is a natural flow refined through pattern recognition!"
Recently we shared a tweet on the âSam Altman & Stewartâ discussion on how to come up with ideas and evaluate them.
He shared that - âGetting Ideas is easy but the hardest part is to evaluate them on which idea is good or not.â He shared a great framework for this⌠Read More Here
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âď¸Written By Sahil R | Venture Crew Team