Answer from Steven Vargas, Director of product, Hipmunk.
Valuations are like housing prices in San Francisco -- they keep going up because of the market more than any other factor. Now, having said that, here's how many investors approach start-up valuations.
Most early-stage VCs target a percentage of your company to own. This percentage will depend on a few things. For example, VCs may want to own more of your company today if you’re in an industry that will require significant capital infusions in the future. Their thinking is: How much money does the company need to receive to push it to the next stage? Furthermore, they’ll ask themselves, how much of the company should they want to eventually own?
Investors target a percentage to own by comparing the amount of money they stand to make if your company is wildly successful with the size of their fund. Most investors seek to have the chance to earn their entire fund back with one big winner. They may invest more in your company to get to that ownership level -- especially if they believe you can get to a big exit. This will increase your company’s valuation.
Most VCs look at the market rate for valuations and make what’s largely a binary (yes/no) decision. They ask, "Do we like this company?” Then they say, "The market valuation for a company in this industry at this phase is X." The VC will know that they will lose out on most big winners if they don't adhere to the market and, instead, choose to invest at lower pre-money valuations.
VCs are under pressure to deploy capital. They’d rather overpay for a company that could be a 10X winner than underpay for a company that they don't believe in.
It also is a signal to the market if company A has a pre-money valuation that is below its peers. Some VCs will stay away from this situation. It's like if you tried to sell a car for well below its market value. This would signal that something is wrong with the car and, in this analogy, the start-up.
This is the factor that most affects a start-up’s valuation. While you may think that having better traction or an innovative business model will affect your valuation, it will not. At least not directly. All that having those qualities will do is put your company in a position where more VCs will say “yes” to the questions of "Do we like this company?" and "Do we believe this company can get to a big exit?" These affirmative responses will bring you more offers. That is the biggest factor in start-up valuations.
Here's a way to look at it: Most Y-Combinator companies immediately have a 25 to 50 percent higher valuation due to the fact that they’re YC graduates. These companies do not always have higher cash flow projections than non-YC companies. They receive higher valuations because VCs know that there will be competition to invest in these companies. After all, many YC companies have a track record of future success.
Now, having said that, you can negotiate pre-money valuations based on factors unique to your business -- factors that could make your exit size larger than industry norms. That will give you a bump in your early-stage valuation, but it may not get you to the same place as your competition.
As a founder, it's great to have a high valuation for your business. However, you always want to be careful of having a valuation that's either too high or too low. If you're valuation is too high today, you run the chance of having a down-round during the next round of financing. This is a bad signal to investors and the market. Earlier investors will likely be diluted more than they'd like, which will dissuade them from participating in future rounds.
On the flip side, you will dilute yourself more than you'd like if you set your valuation too low and try to raise a large amount of capital. VCs (and founders!) don't like when the founding team is too diluted. It makes it tough to raise money later on, as investors will shy away from injecting money into a company whose founders don't have a lot of skin in the game.
So, to summarize, valuation isn't set by looking at metrics like future cash flows. It's set by what VCs expect to make if you are successful, which will set the market rate for a company at your stage in your particular industry. Deviations from these standards could happen based on your specific metrics, but valuations generally tend to change due to competition for investment in your business. If you try to negotiate a valuation with a VC, they will likely pull other levers in the term sheet to give them advantages elsewhere.
What pre-money valuation method to use for pre-revenue start-up? originally appeared on CoFoundersLab — the place to connect, meet, and collaborate with like-minded entrepreneurs.