My first blog post back on Startable after I left the venture capital world was on early stage venture capital valuations. Basically, what an entrepreneur raising a Series A needed to know about how VC’s approached valuing their business.

Having raised money with OfficeDrop, I think that the answer is still pretty much the same – it has nothing to do with DCF’s or other business school theories, but instead is based around what the VC thinks/needs to return to their fund from that particular investment. The following is a bit of an over simplification, but is as close to a “rule” as I could gleam from my time in venture capital.

Series A valuations

Series A* valuations are usually based on percentages – as in, how much of the company does the venture capital fund want to own. Most established venture funds have an established strategy of owning a particular percentage of a company after a Series A investment. A typical, good fund will look to own 20% to 33% of a company after the initial investment. I’ll ignore the rational behind this for a moment and cut to the chase: this means that during a normal two-VC, syndicated Series A investment your startup sells around half the company to the VCs. Raising $4 million? Pre-money of $4 million. Raising $6 million? Pre-money of $6 million.

Getting a higher valuation

Strange as it sounds, this does imply that the more you raise the higher the valuation. I’ll get into the rational behind this “math” later in the post, but first I’ll mention a few things that you can do to try to command a higher valuation.

• Have a name-brand management team. CEOs/CTOs and founders who have been previously successful and previously venture backed command higher valuations for their companies. Recruiting the right one of these executives to your team will increase your valuation. It may very-well be worth the percent ownership in the company that you will have to give them to get them on-board. (Who knows, they may actually be able to help grow the business too…)
• Get multiple firms interested in your startup. VCs can get competitive. If they fear losing the deal to another venture firm they can become more aggressive around the valuation. This is more true than ever. The greater the interest, the better.
• Have real customer traction. It is honestly impossible to do real financial analysis on companies without historical financial statements, particularly income statements. This is why early stage valuations are so nebulous. However, if your startup is experiencing paying customer growth then you may be able to justify using real metrics to concoct a valuation. (As an aside, I find it really funny how much time business schools spend going over valuations in venture capital courses. This is a minor part of how VCs create value and a very small part of how VCs spend their time.)
• Get great seed investors – this is a new one that I’ve just added as I reposted this piece. Seed/angel investments have become really important in 2013 and 2014 – this is how most companies are getting going. And great seed investors can lead you to great VCs and can help you drive great valuations by virtue of their network, name brand and negotiating help.

The rational

So why are valuations dependent mainly on percentage of the startup owned? When making an investment, venture capitalists are already thinking of the exit. They want to know how much they will return to the fund if the company is sold for $50 million, $100 million, half a billion or more. (Don’t try to present the results of this calculation to them; they can do the math on their own. You can do this calculation for your own edification, but you’ll come across as a naive management team if you try to tell the VC how much money they are going to make.) This return is very much dependent on how much of the company they own at the exit. Keep in mind that an early stage investor is likely to experience some dilution if the company will need to raise more funding later down the road, and that the first round VCs will also have to invest some money in these rounds to defend their ownership as new investors come into the company.

The VCs are also thinking about how much of the company is owned by the management team. A good management team has many, many employment opportunities. The VC wants to make sure that the team is properly motivated to help grow the startup. Basically, an important founding team member need to own enough of the startup at an exit to make more (hopefully a lot more) then they would have if they were getting a good salary for five+ years at a big company. The VC can’t let the management team get so diluted that they lose motivation. A venture capital firm needs to think ahead to the likely future financing needs of the business and estimate how much of the business the management team will own at the exit. In truth, the VC will probably only run this exercise for the CEO and the most important technical founder (if they are not the same person.)

There are logical limits to the “raise more money/get a higher valuation” theory I’m proposing. There is likely a narrow band of capital that most VCs will be willing to invest in certain type of companies at the Series A round. For most software and online businesses, this is likely $2 to $6 million, perhaps a bit more on the high end if you have a great team and some traction. So, venture capitalists are unlikely to let you raise $20 million of venture funding at a $20 million pre-money valuation for your online dog food distribution company. They are usually smart enough to not want to over-capitalize a business unless the plan justifies it and the risk/return ratio is correct. If multiple VCs are telling you that they don’t think you can/should raise more than $4 million for your particular startup then you’ve probably found the market clearing round size, and by extension, narrowed the band of the likely pre-money valuation.

Does this make sense? Probably not. But it is the best theory I can fit to the evidence that I’ve seen during my brief time as a venture capitalist. I’d love to hear your theories and experiences.

*I am speaking to the usual “Series A” startup, which usually does not have much in the way of revenues and is often pre-product.