Understanding Valuation: A Venture Investor’s Perspective
You have met with several venture firms, responded to countless due diligence inquiries, and a strong lead investor is finally emerging with intent to submit a term sheet. Only one task remains—establishing a valuation.
At the core of every venture capital financing is a mutually accepted valuation of the company by investor and entrepreneur. A valuation reflects both the entrepreneur’s determination of the acceptable amount of ownership that may be given in return for the venture firm’s capital and expertise, and the venture investor’s determination of the risks and rewards of the investment. This dynamic is often misunderstood—and with harmful consequences.
Understanding valuation from the venture investor’s perspective is crucial. Realizing how valuations are determined and adjusted throughout the life of the company is critical to the investor-entrepreneur relationship and the ultimate success of the company. Valuation methodologies differ by the stage of investment and the availability of quantitative and qualitative data. However, the basic language and components of venture capital valuation is universal, simple, and should be well understood before you engage a discussion of valuation with a venture capital investor.
This article will explain how venture investors consider, construct and justify valuations of early stage companies, and will offer perspective on the dynamic role of valuation throughout the life of a company.
The Basic Math
Any private equity deal will focus on the “pre-money” valuation of the company. This is the estimated or notional value of the company as it stands prior to any purchase of equity. Determining the pre-money valuation of the company, combined with the amount of capital accepted by the company, determines the amount of equity ownership sold in exchange for capital. The resulting valuation after the investment of capital is called the “post-money” valuation. For example, in a company with a pre-money value of $5 million, a $5 million investment would buy a 50% ownership stake in the company.
- Pre-Money Valuation + Invested Capital = Post-Money Valuation
- Price per Share = Pre-Money Valuation / Pre-Money Shares
It is important not to focus just on the valuation negotiation. Just as important as the negotiation of the “pre-money” valuation is the entrepreneur’s decision of the amount of capital to accept, which is predicated on how efficiently the company will use capital.