How do i determine a premoney valuation

The VC method for evaluating companies involves figuring out what the company is going to be worth at the point of IPO, and working back what the company should be worth now, at a very high discount rate.

Let's say that your company could be compared to a few existing public companies in a few years. If you expect to have 20 million customers, and existing companies are worth 5 times the number of customers they have, then one can guess that your company will be worth $100M at that point, and let's assume it will be in 5 years (it is called a terminal value). The comparison can be done in multiples of the profits, or any other method that is accepted in a particular industry.

VCs need high IRRs on their investments in order to compensate for their risks in order to ensure good returns for their investors. If we assume a discount rate of 60% (which is about the figure VCs usually use), it means that the investment is suppose to grow by 60% a year. In 5 years, that means that the company needs to be worth 10.48 times more in 5 years. If I round the number to 10 (to make things easier now), it means that the company is worth now, after the VCs investment, $10M. The reason is that this is the companies' worth after the investment is that without the investment, the company won't be able to grow and reach the $100M goal.

Since the money that is invested in the company increases its worth by the value invested (since it will be an asset the company owns), the pre-money valuation equals the post money valuation minus the investment itself.

In the example above, let's assume that the company needs to raise $2M in order to reach its goals of being a $100M company in 5 years. $10M - $2M = $8M => the pre-money valuation. The VC will receive 20% of the company (2/10) which will be worth $10M.

This assumes one round of financing. In case more rounds are planned, the VC will require a larger share so that it retains the ownership it expects after the additional rounds have been raised (every additional round increases the number of stock and dilutes all existing owners). The calculations are different if the VC plans on participating in the additional rounds, which they often do.

It's impossible to determine a pre-money valuation numerically.

I'm not a VC, but I've seen plenty of pre-revenue business plans. They all, pretty much without fail, predict 1% of a billion dollar market, hockey stick growth (with projected revenue figures to one or two decimal points), etc. etc.

If you don't have revenue then, at their very best, your customer number projections are accurate to two orders of magnitude: who will use this: one person, one hundred people, ten thousand, a million?

What's more, how much they'll pay is only similarly accurate: will they pay nothing, a dollar, ten dollars, a thousand?

So, for pre-revenue, the valuation is based on the multiplication of two guesses. Which means it comes down to instinct. Does this product and team smell right? What are the probabilities of succeeding? What are the risks of investing?

That means that, as Alain points out, how much money you get depends on who else is interested in buying a stake of the company and what the potential investors are willing to pay.

Don't get hung up on pre-money valuation either. It really doesn't matter that much. What's important is that you get the investor and the money you need, on terms that are suitable. Whether you exchange that for 1%, 5%, 10% or 25% is almost incidental.

I would recommend reading David Rose's post on early-stage valuations at the seed stage. http://www.rose.vc/ask/post/456989

Basically if you are raising money at the seed stage you don't want to value the company too highly or you will have difficulty raising money at a higher valuation when you get to the angel or VC stage. So it's important to be realistic about the valuation you are seeking.

Also remember that once you have raised your initial round you will need to use that cash to meet some accretive milestone/s before you can likely raise your next round at a higher valuation, otherwise you will screw over the investors from your first round. Therefore think carefully about your investment requirements and in turn what the pre and post money valuations will mean for your milestones.

It's very simple indeed: you don't. The pre-money valuation is the price of the item you are selling. You can rationalize it as much as you want, but ultimately, it's willing buyer meets willing seller.

The methods of working backward from the exit value to something that makes sense for a VC are fine as a starting point, but they don't justify anything. They are just ways to know that the deal makes sense for the VC.

Put it another way: if your startup is super hot (say Twitter), what matters for your valuation is the fact that you are receiving investment offers from left and right. It's a market, make sure you get multiple offers if you want to sell high.

Turns out it's not hard at all. Just sell one-billionth of one percent of your company to somebody for $1, and poof, your valuation is $100,000,000,000!

Think it won't work? Jason Fried did it.

I'm preparing my own press release immediately!

Scott

Supply and demand. We raised some low-level seed capital by saying, "We want $10k and don't want to give away more than 5%. Who's willing to give us what we want and take what we'll give?" That got us the money we needed, at a lower percentage than we wanted to give away.

You don't set the valuation. Investors do. For seed rounds in IT (software, web) I am seeing pre-moneys between $1.5M and $3M. Absolutely none higher.