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How VC’s Value Early Stage Companies
Thursday May 13, 2010 by Rob Go - Entrepreneur
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 from. B-school students
are trained to believe that valuations are driven by the present
value of future cash flows, which is a function of - 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 as 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.
Rob Go is a Co-Founder of a new entrepreneurial venture and former Venture Capitalist with Spark Capital. This blog post was originally published on May 10, 2010. You can find this post, as well as additional content on his blog called robgo.org.
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