Entrepreneurs often spend too much time trying to figure their companies valuation with fancy forecasts, spreadsheets, financial models, growth targets, multipliers, and the list goes on and on. It may surprise you to know that most venture capitalists usually determine the valuation of a company in less than five minutes by asking a few simple questions that often times don’t include a five year profit and loss statement or forecast.
David Freschman, Venture Capitalist with Innovation Ventures says, “Valuations are far from an exact science. By asking the Entrepreneur a few pointed questions about their idea and business model, I can usually get pretty close the pre-money valuation.”
At the center of every venture capital deal is a mutually accepted valuation of the company by the entrepreneur and investor. Valuation is generally determined by the acceptable amount of ownership the Entrepreneur is willing to give up in return for the venture capital firm’s investment and expertise, along with the VC firm’s risk and reward of the investment.
Most investment deals focus on the “pre-money” or “before the money” valuation of the company. The pre-money valuation is the estimated value of the company before any company stock is purchased. The pre-money valuation 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” or “after the money” valuation.
For example, in a company with a pre-money value of $1.5 million, a $1.5 million investment would buy a 50% ownership stake in the company. The post money valuation would be $3.0 million.
Formula: Pre-Money Valuation + Invested Capital = Post-Money Valuation
Valuation methodologies usually differ by the stage of investment. Before entering into discussions with venture capital firms or investors, you should familiarize yourself with the general valuation stages and the components of each.
Early stage investing is far from an exact science as this type of company is usually an entrepreneur with an idea. Valuations at this stage are generally driven by factors that by their nature are subjective. These include evaluations of the CEO and/or executive team, intellectual property, projected go-to market timing, expected path to profitability, and estimated capital needs and burn rate.
During post revenue stage investing, intermediate data points such as events demonstrating proof of concept and product validation will be strongly determined. Other factors that are considered are scalability, sales and marketing execution, pipeline, and cash burn.
As the company reaches the market penetration stage, more quantifiable data is produced in the form of operating statistics and performance indicators. Actual results allow investors to more accurately model quarterly and annual revenue, cash burn, pipeline close rates, backlog, bookings and enterprise valuation.
You should be able to identify what stage your company is in by using the table above. Once you’ve identified your company’s stage, it is now time to shop the market for the best investment deal.