In an earlier post we defined the term “pre-money valuation" and explained how this valuation is used to calculate the price per share at which stock is sold in a VC financing. Actually determining this “pre-money” or “pre-investment” valuation, though, is often one of the most fundamental terms for founders and investors to negotiate, as it effectively sets the relative percentage ownership levels of the two groups (assuming a fixed investment amount).
Despite this fundamental character, “calculating” an appropriate valuation (or even a range thereof) can be quite difficult with startups, particularly pre-revenue or pre-product companies, for which traditional financial valuation methods (such as revenue multiples or discounted cash flow analysis) often have limited applicability. Accordingly, many investors believe that valuing startups is more of an art, based on intuition and experience, than a science. As a result, valuations in VC financings are often driven more by market supply and demand forces than by empirical calculations, trending up or down based on the availability of VC funds and the supply of new startups (see, for example, the recent commentary on increasing valuations in Silicon Valley and Fred Wilson's post on frothy valuations).
However, several recent blog posts from prominent investors have provided interesting insight into how, at least some, VCs approach valuations from an empirical perspective, which are worthwhile reads if you have not done so already: