In a priced investment round, a valuation (the “pre-money” value) of the company needs to be determined. The valuation determines the price of the stock which, given the amount of money the investor is investing, determines how much of the company the investor owns.
In an angel investment, the valuation is generally proposed by the company. In a venture capital investment, the venture capital firm generally proposes the valuation.
How does a VC come up with a valuation? It’s part art and part science and part of function of the market (i.e., what valuations are similar companies receiving from other investors).
Valuation Isn’t the Only Important Term
Don’t fixate too much on valuation. There are other critical terms which, in ways, can be even more important than valuation. Example: liquidation preference. If in an exit (e.g. the company is bought) investors may try to include liquidation preferences that pay them a multiple of their investment before the founders receive any proceeds at all. Depending on the deal, there might not be any funding left for the founders! Work with your attorney to make sure you understand all the terms in the term sheet!
The Question of Control
One issue that often worries entrepreneurs is that if they sell 50% or more of the stock in their company, then they lose control. In reality, founders lose quite a lot of control as soon as they accept investment funding, for a number of reasons:
- Investors my get a seat on the Board of Directors, which certainly conveys significant control – the Board hires and fires the CEO, for a start.
- Investors often receive the right to veto major actions such as acquisition offer or a major purchase or investment.
- You’ll likely need to close a future round of funding, and that’s hard to do if you current investors don’t support you by investing in that next round. That gives investors a great deal of control as you cash is marching toward zero!
The good news is that most investors understand that the management team and, for that matter, all employees need to be motivated. Employees need to own a major share of the company, or there will simply not be enough potential pay-off to justify the great amount of effort required. In each investment round, the investors should be willing to add to the option pool, and add to options that have already been granted, to make sure that employees remain motivated.
How to Increase your Valuation
To maximize our valuation, you can:
- Make as much headway in your business (developing product, getting revenue, etc.) before asking for venture funding
- Make sure that your market opportunity is large enough to justify VC interest
- Choosing a hot market doesn’t hurt; if there’s lots of investment in your market, and your company offers a differentiated opportunity, it bodes well for your valuation
- Competition: if multiple VCs want to lead your round, than you have demand and supply working for you.
- Build the strongest management team you possibly can. A strong team will increase your valuation.