How do VCs value young companies and is a higher valuation always better

So as I am catching up today from a weeks vacation just of the coast of North Africa, I thought I would post an article from a friend who works for Scottish Equity Parteners...to let me get my thoughts straight before I launch into a new series..

How do VCs value young companies and is a higher valuation always better?
By Stuart Paterson

Contrary to popular wisdom, VCs consider it vital for entrepreneurs to be comfortable with the valuation of their company so that they are highly motivated to succeed.

Critical factors affecting valuation are the prospects for returns and the inherent risks associated with getting there. VCs focus on the prospect of a significant capital gain so potential exit value is key. Factors influencing this include the size of your market, your likely share and revenues, and above all, the likelihood of attracting a trade buyer or achieving IPO.
VCs need at least a 3x return on their investments overall to make the economics work. Situations differ, but since some companies inevitably fail, a high risk start-up requires the potential to achieve at least a 5x return. A prospect of 10x can lead to a higher initial valuation, providing that is a credible outcome.

The earlier the development of both company and market, the higher the risk. Valuations take this into account. VCs also factor in how strong and sustainable your competitive advantage is and the experience of the management team. They consider whether the product can be easily copied and how you will take it to market and achieve revenues?

Securing the participation of a syndicate of high calibre VCs at the start of the funding process can help attract other VCs to subsequent rounds. You should focus on attracting investors with a real knowledge of your sector and realistic expectations and time horizons to avoid being pushed into a premature exit.

You may need very large amounts of capital to succeed. For example fabless semiconductor businesses face high costs in designing, developing and marketing their technologies while information and communications technology companies have to offer complete solutions including software and subsystems. VCs will not usually commit total funding requirements up front and will more likely invest in stages once certain milestones have been met, so companies should aim to see an increase in valuations in successive rounds, as well as at IPO or exit.

A very high initial valuation isn’t necessarily the best thing and it is better to take a long term view on building value. Many VCs won’t invest in A rounds because their value hardly increases in the B Round, resulting in limited reward for taking a high risk in investing early.

If initial valuations are excessive, investors may think the next round is too expensive. Worse still, if your initial aggressive assumptions aren’t sustainable, a round with a lower valuation means giving away a lot more equity. Take a realistic view and remember that it is in the interests of the VCs for you to be incentivised to deliver long term value.

Consider carefully the milestones you need to hit to demonstrate that you are making solid progress at each round and remember that it usually takes longer to achieve them than you think. You should prepare for fundraising nine months before you need the cash as being forced into unplanned financing results in greater dilution . Raise enough at each stage to achieve the milestones which will trigger more funds in subsequent rounds and take more than you need if it is on the table.

First round valuation is less important than attracting the best VCs who can add real value as well as capital. It is important to consider whether you can be open and honest with them, whether they have realistic expectations concerning the development of your company and whether they will provide the follow on investments you need. That is the way to maximize your valuation when it really counts – at exit.