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Getting the right valuation from your startup is about supply and demand

Your startup’s “pre-money valuation” is the total value of your company before an investment is made: it determines both how much equity an investor will receive in return for their investment, and therefore how much equity you, your team and existing investors will retain once the new investment round is completed.

Pre-money valuation is important to you and your existing shareholders because the more equity you sell to investors, the less you have to sell when it comes time to sell all or part of your interest in the company. But the pre-money valuation also matters to potential new investors because the main way they reduce the risk of their investment in your company is by lowering the pre-money valuation so they can buy more equity for their money.

(For simplicity’s sake, I’m going to work with pre-money valuations on priced equity rounds here. If you’re raising a SAFE or convertible bond, when I say “pre-money valuation” you should think “valuation limit”).

It’s in your best interest to raise at a higher pre-money valuation, and it’s in the best interest of investors to push for a lower pre-money valuation, so how do you find out a fair pre-money valuation?

If you haven’t monetized yet and you raised $500,000 a year ago at a pre-money valuation of $3 million, is your startup still worth at least $3.5 million? It depends.

The first step is to accept that there is no such thing as a fair pre-money valuation, only one that the current market will accept. Pre-money valuation is a matter of supply and demand, and you and your startup only control the supply half of this equation: the level of investor interest, the rate at which the round fills up, and the number of investors interested determines the ask.

If you raise $500,000 and you have $700,000 in investor interest at a pre-money valuation of $3 million, and you still have enough runway left to close the deal, you may be able to meet demand for increasing your pre-money money valuation to $3.25 million or $3.5 million. If you feel like you’ve pitched to all likely prime investors and you’ve only committed $100,000 for your $500,000 round, you might find interest where you once got a “no” by lowering your pre-money valuation and go back to them.

Some will tell you, “what investors will pay is based on what you think you’re worth,” but that’s both true and false.

What you think you are worth comes into play, in that you don’t get what you don’t ask for. And you (and any existing investors in your startup) may have a fixed price anchor based on the post-money valuation in the previous round, or perhaps the valuation of a comparable startup that raised a similar amount at a similar stage in recent history, or any other startup like yours that is ramping up at the same time.

tackling FOMO

But that price anchor is an illusion – the markets are volatile and while the next few years don’t look like another Dotcom crash yet, they don’t look great, so your pre-money valuation is likely to fall as the month goes by unless you quickly gaining evidence in customer traction and revenue growth at the same time.

Speaking of changes over time, let’s also consider the speed at which your round closes.

If you have a first call with a VC with no commitments for your $500,000 round, then a second call two weeks later with $400,000 of the round already committed, it feels like the round is closing very quickly and if the investor is interested, the pressure will be great and you will have some leverage. If you meet them six months after your initial call and you’ve only committed $200,000 for the round, there’s no FOMO (Fear Of Missing Out) and no pressure on the investor to consider a higher valuation.

Another factor is the size of the funds you earn interest from. All else being equal, a larger fund is more likely to invest at a higher pre-money valuation than a smaller fund. A smaller fund manager has less capital to make follow-on investments in later rounds at higher valuations and tends to buy as much equity as possible in the first round.

A larger fund is more likely to see its initial investment as a way to have an option to invest in follow-up rounds if your success continues.

Uniqueness is another variable in determining investor demand. For many VCs, if they’ve never seen anyone work on what you do, that will make you seem more interesting and potentially increase your potential appreciation. But some VCs will be just the opposite – they need the comfort level they feel when they’ve picked out 4-5 startups that are all similar to yours and decided that your startup is the best in the field right now.

In that situation, demanding too high a valuation may cause the VC to invest in one of your competitors instead of you.

‘A list’ of VCs

The other factor to consider is whether investing in your startup is an opportunity to build a relationship with an ‘A List’ VC over other VCs without ‘A List’ status.

You might be excited about the bragging rights when you say an A-list VC led your round, but instead you should think about whether other lesser-known VCs would be excited to sit at the same cap table as the A Listers, and or that could give you the chance to push up your pre-money valuation.

The final factor to consider is really the only one over which you have any control: how quickly do you turn hypotheses into evidence? How fast can you build a product? What evidence do you have that customers like using it? How fast are the number of customers and turnover growing?

Of course, if you didn’t want to accelerate all those things, you wouldn’t be working on attracting investment, but in the battle of supply and demand valuation, most of the demand is reserved for the most desirable tech startups: the startup that can plausibly continue to grow without increasing a round.

All of this probably leaves you wondering: How do I know what the VCs are thinking when I pitch them?

All I can say is ask them; polite, but don’t be afraid to do so. They may not always answer honestly, but hopefully you can read between the lines.

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Shreya has been with australiabusinessblog.com for 3 years, writing copy for client websites, blog posts, EDMs and other mediums to engage readers and encourage action. By collaborating with clients, our SEO manager and the wider australiabusinessblog.com, Shreya seeks to understand an audience before creating memorable, persuasive copy.

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