How VC’s Value Early Stage Companies

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 headscratching (Square, Foursquare, Groupon, etc).

It begs the question of where these valuations come ffrom.  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
clamouring 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.

Sorry for the typos, this was written on my iPhone.

Rob Go

Thanks for reading! Here’s a quick background on who I am: 1. My name is Rob, I live in Lexington, MA 2. I’m married and have two young daughters. My wife and I met in college at Duke University - Go Blue Devils! 3. We really love our church in Arlington, MA. It’s called Highrock and it’s a wonderful and vibrant community.  Email me if you want to visit! 4. I grew up in the Philippines (ages 0-9) and Hong Kong (ages 9-17). 5. I am a cofounder of NextView Ventures, a seed stage investment firm focused on internet enabled innovation. I try to spend as much time as possible working with entrepreneurs and investing in businesses that are trying to solve important problems for everyday people.   6. The best way to reach me is by email: rob at nextviewventures dot com