There is one trick question that investors almost always ask, and it’s guaranteed to make founders uneasy: “What are your expectations surrounding valuation?”
For most founders, it’s the perennial Goldilocks scenario. Throwing out a number that’s too high might push investors away, while an amount that’s too low might trigger the question, “Why so low? What’s wrong with this business?” and leave shareholder value on the table.
And if it’s just right, most investor’s knee-jerk response goes something like this: “Let’s see how much I can work this founder down to a better price.”
Founders are at a distinct disadvantage in the valuation game. By design, investors play this game far better than most founders ever will — a VC might do multiple deals in a quarter, but a founder might approach markets only once every couple of years.
So, instead of having to throw out specific numbers that will inevitably be challenged, here’s a solution:
Don’t throw out a number
The more you seek to understand your investors’ thoughts on deal-making, the better you’ll be at getting to that deal.
The most confident (and valuable) founder response to the infamous valuation question starts with: “We’re letting the market price this round.”
When delivered correctly, it implies you’re taking offers, you aren’t desperate and you’re confident you’ll close a deal at acceptable terms.
But if that’s all you say, you’re in trouble because it can also be interpreted as “We don’t have a clue” or “We’ll take what we’re given.” After all, you need to give a baseline indication of your expectations if you actually want to close a deal.
Jay Levy, co-founder and managing partner of Zelkova Ventures, explains, “When speaking with VCs, founders should give some indication of their valuation expectations coming into the conversation. It’s important to know that everyone is on the same page, because it would be painful and unfortunate for everyone to advance toward a term sheet only to realize that expectations are misaligned.”
Gather your valuation data points
To substantiate your market-based valuation approach, you have to begin early. Start by pre-pitching the investors for your next round to gather valuation data points and have low-stakes conversations to build in the presumption that “we’re probably too early for you, but in 12-15 months, we’ll most likely be a great fit.” In these chats, always ask how they might approach valuing your company when the time would be right (i.e., in your next round, 12-15 months from now).
Don’t ask for a hard number — anybody can give you a number or range, but that doesn’t make it meaningful. Valuation approach and rationale are far more valuable to investors, because the final figure valuing you at $20 million or $200 million is an output of approach and rationale.
When pitching, listen for elements of the approach; that “math equation” (e.g., 5x-10x next year’s revenue, 10x-20x EBITDA and so on). You’re also listening for justifications of why an approach makes sense. This may sound something like, “Recent transactions in the space indicate this is roughly where the market’s at.”
Armed with a couple of valuation rationales from next round’s investors, it’s time for you to pitch this round’s investors.
Show you know what you’re doing
When they pop the valuation question, here’s your full-power response:
We’re letting the market price this round. Ultimately, we’re fairly relaxed that we’ll end up putting together a deal that makes sense with the right investor. However, some of the others we’ve spoken with have said they might approach valuation somewhere in the range of (quote the approaches you’ve gathered) on our next round, with some of the drivers being (quote the valuation rationales you’ve gathered).
Quoting the next-round investors’ valuation guidelines to investors you’re approaching for this round can be incredibly potent. It’ll say everything you want to say, without saying it:
- You’re well educated on valuations in your business’ space.
- You know which metrics are most important to work on to boost the value of the company after they invest.
- You know who to go to for next round’s capital.
- You’ve definitely been speaking to other investors — and they’re sophisticated.
Adelle Archer, CEO and co-founder of Tiger Management-backed Eterneva, has successfully used this strategy in the past. She explains, “When you acknowledge that certain investors can bring added value beyond money, signal that’s important to you and embrace flexibility on terms. That can be a very attractive quality.”
But being open to term sheets isn’t everything, she notes. “Confidence alone won’t be sufficient to get you through the valuation discussion. You want to have a rough idea of the valuation realm you might end up in. Any insight you gather from other investors about how they arrive at a valuation will help you tremendously,” she said.
Founders that take this approach project more than just confidence — they show that not only have they done their homework, they’re also mature enough to understand the value of flexibility in negotiating a fair valuation in the context of a significant investment.
But don’t stop there
Investors appreciate a well articulated and confident response to the valuation question, but you should do better. Follow up by asking the investor “Out of interest, how might you approach valuation for a business like ours?” Listen carefully, probe for details, then add that response to your talk track for the next meeting.
To take this strategy even further, questions you will want to ask every VC you speak with include:
- Do you have a target ownership range?
- Are there any concerns you might have about our valuation that you’d like to discuss right now?
- Are there any firms that you like to co-invest with?
Every additional valuation approach data point you gather enables you to have a better, more informed conversation with the next VC. When you’re signaling flexibility and actively troubleshooting as you go along, you may find that you’ve done a great service to the eventual success of your raise by addressing potential problems early and proactively. Beyond that, having a soft referral to another potential co-investor never hurts.
The more you seek to understand your investors’ thoughts on deal-making, the better you’ll be at getting to that deal. Rather than letting valuation become your biggest source of anxiety, build true deal FOMO through well-informed confidence.