Find your lead investor and signal your valuation expectations

The most frequent question I get asked by founders (other than what does DC stand for) is how to calculate the valuation of their startup. Unfortunately, there’s no simple formula to pop out a number. Founders need to negotiate with investors to find a value that works for both sides.

Investors look at valuation as risk vs. reward, which in turn comes down to the various elements we look for in the pitch. The risk is determined by market traction, team experience, competitors, and competitive moat while the potential reward is a function of market size, acquisition multiples, and additional funding requirements.

There’s no spreadsheet that can take these factors and churn out a number. Investors mix their gut instinct on all these factors, then compare the company to the hundreds of other startups we’re pitched to invest in the best bet we can find.

So in the end, the valuation is simple: it’s the amount investors are willing to pay.

As a founder, life would be simple if you could pitch a hundred investors and takes bids in an auction. But that’s not how the process works. Instead, you’ll pitch to a VC fund or an angel group and if you don’t specify the valuation during the pitch, that will always be our first question.

If you make the mistake of stating that the valuation isn’t determined yet, you’ll be politely told to come back when it is. And don’t bother to state the obvious that you’re still negotiating or it depends on investors.

Even if the valuation isn’t set yet, investors expect the startup to provide guidance on your expectations.

The Startup Needs to Put a Number on the Table

Listening to pitches, I often get excited about a great new startup. It isn’t until we get to the end of the pitch that I find out the company is looking for a $20M valuation whereas I think they’re worth $6M at best.

I might be convinced to invest anyway at $8M, and $10M isn’t completely out of the question. But there’s no way to bridge the gap to $20M. So I wish you the greatest success and politely decline.

What I want to avoid is getting excited about a startup, spending days in diligence assessing the risk and reward to come back and offer a $6M valuation, only find out the founders won’t accept anything less than $20M.

So I’m not going to put any effort into evaluating a company unless I know we’re in the same ballpark on valuation terms. Especially in the earliest rounds when it’s not unusual for inexperienced founders to have unrealistic expectations, I need the company to give me an idea of what they expect.

Setting an early-stage valuation is never easy. A tempting solution is to try to avoid it by proposing a discount off the next round valuation instead, kicking the whole valuation discussion down the road until much later.

That’s fine for the friends and family round which is more like donations to support the founders than serious investing. It’s fine for accelerators and incubators which aren’t negotiating valuations of each individual startup in their cohort. But it doesn’t work for investors who are looking for financial returns. As I discussed in this earlier article, for most experienced investors, investing without a valuation is a non-starter.

So it’s up to the startup to put a number on the table. If you set the valuation too high, you won’t get any investment. Set it too low, and you’re giving up more of the company than you need to. What do you do?

Find the Deal Lead

A valuation is a negotiation with investors. The first thing to do is find the right group of investors to negotiate with.

Since all investors in the round get the same valuation and terms, one investor needs to be the lead to negotiate for everyone. The lead is expected to be the largest investor in a deal (or at least one of the largest) and take a seat on the board.

Investors who won’t lead the deal are called followers. Deal followers will invest only after the deal terms have been set by the lead.

When talking to investors, ask them whether they’re deal leads or followers. It’s one of the basic things to ask each investor, including round, typical check size, and sector focus. It’s not unusual for a fund to be a lead at one stage and a follower in others, or to lead in a sector they’re familiar with, but still make smaller investments as a follower in other sectors.

Individual angels will rarely be the deal lead since they’re unlikely to be the largest investor and don’t have the resources to run a detailed due diligence process. Strategic investors and company insiders are also not suitable as deal leads since they’re focused on criteria other than financial terms.

To get started, you need to find not just investors but a lead investor. Still, it’s worthwhile talking to as many investors as possible, not just to build a pipeline of potential followers, but also use them for guidance on terms they’d find appropriate.

How to Negotiate With the Lead Investor

Once you’ve found your potential deal lead, when they ask your valuation the valuation, the wording to use is: “We’re targeting $X million.”

“Targeting” is the key word to tell investors the valuation is negotiable. Obviously, as your target, it’s the high end of what you’d find acceptable. As in any negotiation, don’t start with your best offer, but keep it reasonable. If you think the company is worth $8M — $10M, say you’re targeting $10M.

If the targeted valuation is not close to what we’d find attractive, we’ll simply decline. But if we’re in the ballpark, we’ll begin the discussion to find a value that works for both sides.

An alternative to specifying a target is to give a range, i.e., “We’re targeting a range of $8M — $10M.” That has both the advantage and disadvantage of making it clear that anything under $8M is unacceptable.

I recommend just listing the high-end target. First, if we think $7M is appropriate, with a range that starts at $8M, we’d probably just decline and you’d lose the chance to negotiate, or at least get valuable feedback on what we think is appropriate. It also puts the onus on the investor to offer our valuation. Second, if I hear a range of $8M to $10M, I assume the real target is $8M.

In general, we’re not trying to push founders on valuation. This is the beginning of a collaborative relationship, not a 1-time transaction. We need to find terms that are fair to both sides rather than driving the hardest bargain we can. And valuation isn’t the only line on the term sheet that matters, just the first one to discuss.

So think of your potential investor as a partner to work with to set terms you both find reasonable rather than someone you’re battling against. Lawyers can be helpful for avoiding mistakes and turning the terms into a contract, but the founders need to be negotiating directly with investors to build that relationship.

What Does “Valuation” Even Mean

To simplify the discussion, I’ve ignored that fact that valuation without context is meaningless. There’s a huge difference between a pre-money valuation cap on a convertible note, a post-money valuation cap on a SAFE, and an actual valuation on preferred shares.

Simply stating a target valuation or valuation cap without specifying the investment vehicle isn’t very useful. So the full answer to the question about valuation is: “We’re targeting a raise of $1M on a $10M post-money SAFE.”

That will tell investors everything we need to know to get started, and set the scene to begin discussing details.

But keep in mind that finding the right investors who share your vision and can contribute to your success, especially for the lead investor, is far more important than who will give you the most money at the highest valuation.

To Kill a Unicorn – a Silicon Valley Mystery

Interested in startups? You’ll love my mystery novel about SüprDüpr, a Silicon Valley startup that claims to have invented teleportation. Now the chief scientist is missing, and his hacker friend has to figure out if the company is a fraud or something more sinister.

Order your copy today! 
https://www.amazon.com/Kill-Unicorn-DC-Palter/dp/1950627616