The following is the first in a series of 4 excerpts from  “How to Negotiate a Winning Term Sheet and the Best Valuation for Your Company”

Possibly the hardest thing for an entrepreneur to come to terms with is knowing how to value his or her company – especially when it is a startup or fast growing early stage business.

So how do you ascertain the pre-money valuation for your company or business idea?

First, forget the math. This is not about spreadsheets that calculate the value of future discounted cash flows. And forget about discounts to public company comparables. You’re at too early a stage to make that meaningful.

Determining your valuation is an art, not a science. And it’s about the art of negotiation between you and the investors.

But before we get into strategies and tactics on how to negotiate the best valuation, let’s set the most basic parameters and expectations:

If you are raising a Series A round from professional institutional VC investors and you can get away with selling 20-40% of your company, you’re also basically in the zone.

A few major caveats about the above percentages. First, if you’re selling that equity to people who cannot truly add strategic business value -- you’re probably giving away the store.

Two, depending on the type of company you have – whether it is technology oriented and capital intensive or not – the variance within those ranges will be extreme. Starting a business services company versus a semiconductor manufacturing plant are two completely different animals. The cost of capital at the Seed or Series A stages will be very different due to the inherent risks and need for continuing capital in these two types of businesses.

So, how do you negotiate the best pre-money valuation and minimize dilution of your ownership in your existing early stage business or startup idea?

By coming to the table in the strongest position possible from a business perspective.

And how do you come to the table in the strongest position possible from a business perspective? By adhering to the following principles outlined in:

“The 12 Secrets of Negotiating the Best Valuation for Your Company”

Here are the first three:

SECRET #1:

Timing is everything: Only (try to) raise money when you don’t really need it. If you’ve got an existing early stage business, and you’ve got a burn rate and are running out of cash to meet payroll in 8 weeks – it’s too late! It’s not to say you can’t raise money (or part of the amount you are seeking) -- but you will have all sorts of leverage working against you. Don’t wait until you’re running out of money to start raising capital. The more desperate you are, the more professional investors will proactively use that against you to take the deal down to the last minute and extract from you terms that will be painful. The more risk on the table, the lower the valuation. The more desperate you are, the lower the valuation. The more you need the money, the lower the valuation. It’s not that professional investors are mean people – that’s their job!

If you think it will only take 3 months to raise capital, start talking to investors in earnest 6 months out – or even earlier. This applies to both pure startups as well as Series A companies. Plum the investors’ interest level. Get a sense of what risk factors they will want to focus in on. And see what you can do in that interim period to mitigate those risks so that you can get the deal done within the 6 months timeframe. Remember, the first part of the investment process will be to gauge investor interest and “pushback” issues such as stage and risk profile. Don’t wait until the final 3-month window to scout out the investment landscape and determine how investors perceive your risk profile! Start early and use the interim period wisely in order to come back to the table in as strong a position as possible.

SECRET #2:

Make sure to put your own “skin in the game.” It will give you critical negotiating leverage to be able to look investors squarely in the eye and remind them that you believe in this concept so much that you’ve put you own money into the company, or money from your immediate family. Will it get you twice the valuation the investors are offering? No. But they will have to respect your commitment to the business opportunity as evidenced by your cash outlay.

And it’s not enough to count the “opportunity cost” of lost wages or deferred salary. Professional investors expect you to put in sweat equity. That’s what entrepreneurs do. What they do want to see is that you believe so much in this vision that you’ve actually written a check.  

Again, in the subtleties and nuance of the negotiating dynamic, putting your own skin in the game will make you stand out from other entrepreneurs who have not similarly demonstrated their commitment to their early stage venture.

SECRET #3:

Minimize the leaps of faith: Get your Network in place to guide you through Exit. The more relationships you have in place to help you get to Critical Mass and ultimately through an Exit, the stronger position you will be in order to negotiate valuation. Again, this is not a one-to-one correlation on the number of high-profile Advisory Board members to valuation, for instance. However, the more you can demonstrate that you’ve already lined up a network of quality people to help guide you Day 1 through initial technology development, initial customer introductions, and the recruiting of top talent -- the stronger your negotiating leverage will be in demonstrating to investors your ability to do the “heavy lifting” necessary to make your early stage company successful. Again, there can be no guarantees of success. But lining up people Day 1 who can help you to lower your risk profile throughout all stages of development will give you an important edge in negotiating final valuation.

ABOUT JEFF PARNESS