Most venture capitalists bear witness to thousands of investment deals and have an advanced intuition on market valuation. Founders, especially first-time entrepreneurs, often possess limited knowledge of the nuances of the market and fail to optimize the negotiation process as a result.
Failure to recognize “asymmetrical information” in discussions with a VC can prevent founders from closing the deal entirely. Mark Suster talks about valuation communication in his article“How to Talk Valuation When a VC Asks” onBoth Sides of the Table. Check out the post for his recommendations on VC valuation conversations.
Not only do founders often struggle to define valuation from round-to-round, but we also need to better understand what a VC needs to hear about our valuation to make the best investment decision.
The earlier the startup, the riskier the investment. On the other hand, established companies with several years of consistently increasing sales provide a reliable measure of value to potential investors.
Many early-stage founders have little to no sales and rely on a financial forecast based on myriad assumptions. While this creates enormous risk for potential investors, the payoff may reap proportionally enormous returns.
As such, founders need to understand what type of VC we are dealing with. Does the VC like to invest in ventures early in the game or with a more established track record?
VCs often fulfill a relative investment “quota” based on firm valuation. For example, a VC may primarily invest in startups around the $5M valuation mark but invest less frequently in startups on both ends of the spectrum. Knowing what type of VC we are dealing with can help us present communication more effectively to garner an ideal investment solution. VCs with smaller budgets may look for early startup deals that require less cash and more equity.
Even more, understanding our VC lets us know when it’s time to move on. For example, if your most recent valuation sits around $40M, but the VC in conversation typically invests less than $10M at a 20% or greater valuation, your startup may not be a good fit.
VCs often use benchmarks that help them do evaluations before investing.
Business plan and concept, risk judgment, market opportunity, and management team all play a vital role in making this decision for a VC. Even with all of these boxes checked, you can eliminate VC interest by overstating or understating valuation.
To achieve funding from a VC, communicate the financial data you have and avoid overly-optimistic growth assumptions. Particularly in early conversations, let the VC drive valuation discussions to gain their perspective before sharing hard numbers.
For these reasons, VCs often ask how much capital you’ve raised so far. Not only does this information help them understand fit with their firm, but they also need to realize the growth you achieved using investor money.
VCs also ask this to understand whether your last round was fairly priced. If the VC determines your last round was overpriced, they may end the conversation early to avoid investing in a down-round or a flat-round.
If your startup enters either of these, it means your team is willing to take on more cash investment, but the price of your company is not improving. This burdens your team’s morale, increases founder dilution, and reflects poorly on your current investors’ books. A reputable VC will rarely take on that additional risk. Essentially, a down-round implies that the previously negotiated price of your company was based on optimistic assumptions that proved untrue (CooleyGo).
So when a VC asks how much capital you’ve raised and what you’ve done with the money, start with the simple facts. If your last round was closed at an overpriced valuation, prepare your team for that conversation with the VC and ready your discussion points.
Check out our post next week when we talk about how to negotiate with a VC without revealing your valuation expectations.