What are your expectations surrounding valuation?

Leading into a world of unknowns, a world where you don’t have the answer, the best you can do is to ask better questions, as well as help those around you to do the same – Pascal Finette

During an AMA session a couple of days ago, one of the founders asked me a pertinent question - "How do founders handle valuation conversations with investors?" This is a question that investors almost always ask and is guaranteed to make founders uneasy - "What are your expectations surrounding valuation?" Finding the "Goldilocks" valuation number can be challenging. If you quote too high, investors may get pushed away, while quoting too low may signal that something is not great with the business, leaving significant shareholder value on the table.

To answer this question, most founders do one or more of the following: 

• Speak to experienced founders or advisors
• Try to find benchmarks in recent transactions
• Wait for other investors to offer terms before deciding on the right number

However, most of the time, the answer is driven by gut feeling. It might be useful to think about how VCs actually value the company: 

A startup's value is the funding amount divided by the equity stake that the startup is diluting. Hence, if the startup is raising $1Mn from the VC and diluting a 20% stake, the value of the startup becomes $5Mn ($1Mn divided by 20%).

In fact, valuation is never directly targeted or sought after. Rather, the eventual valuation emerges once the VC and the founder agree on the funding quantum and desired equity stake. The target equity stake is determined by the VC's estimation of what will be a "meaningful" stake (say 5-10%) at the time of exit, meeting their internal exit outcomes for the startup after several future rounds of dilution. 

Therefore, the original question of "What are your expectations surrounding valuation?" becomes "What % of my company would I trade (read dilute) that makes it worthwhile for me to partner with this VC?"

The answer theoretically would be: You should give up x% of your company if what you trade it for improves your average "outcome" enough that the (100 - x)% of the company that you have left is worth more than the whole company was before.

For example, if an investor wants to buy half your company, that investment has to improve your average outcome by more than double for you to break even.

In the general case, if x is the fraction of the company you're giving up, the deal is a good one if it makes the company worth more than 1/(1 - x).

In the above example, x=0.2 and 1/(1-x) is 1.25. So you should take the deal if you believe the VC can improve your average outcome by more than 25%. The higher the estimated impact, the better your deal would be. 

VCs impact the average outcome of the company with the following three value adds: 

1. Signaling value - If a top-tier VC backs the company, it almost automatically increases their ability to win customer meetings, talent, next-round funding among other benefits
2. Financial value - providing VC's experience, network connections, and advice on fundraising; help with deciding when and how to exit the company
3. Operational value – driving GTM, getting additional clients/ customers, co-developing products, hiring next level talent and other day-to-day tasks of building a company. 

Let's use an example to demonstrate the impact of operational value VCs create Let's say a VC is offering to invest in your company at a valuation that is 10 times your current revenue and they are asking for a 13% ownership stake in exchange for their investment.

If you believe that VC's involvement alone can increase your company's revenue by three times. Even if the next round of funding only values your company at half the multiple of the current round (5 times revenue), it would still be worth it for you to take the VC's offer. That's because with their involvement, the value of your company would increase by more than 50%, which is a significant uplift in value compared to what you are currently trading i.e 15%.

Of course, other factors to consider in a VC deal. It's never just a straight trade of money for stock. Most early-stage investors can add value to the company by applying the first two levers mentioned above - signaling value and financial value. However, they rarely help in the third one - operational value, largely because they are not in the business of running operating companies. That's where Corporate VCs like TELUS Ventures can add unique value in terms of operational support with GTM, bringing clients with their clients, adjacent business areas, and support teams.