Talk Opportunity, then Price

I remain surprised by the number of high impact investors here in Wisconsin, seemingly sophisticated angels and even a few professionals, who think that entrepreneurs should include a deal’s pre-money valuation in their base business plan and investor presentation.  In a post last year, I argued that, from a strategy perspective, entrepreneurs should postpone the valuation discussion until later in process – after the potential buyer has, hopefully, started thinking that, pricing aside, the deal is one they want to know more about.  In this post, instead of focusing on the negotiating advantages (for the entrepreneur) of postponing the valuation discussion, I will instead focus on some core pricing issues that make leading with price impractical, unwise and, frankly, naive.

1.  First, many deals evolve substantially between an entrepreneur’s first contact with investors and the closing.  Valuation-enhancing team members might join (or leave) the team: Key technology milestones may be reached: Important customers or partners may sign on: Market conditions may change.  In short, in the time-compressed start-up world, all sorts of things can happen between “first contact” and the term sheet discussion – things that make setting a valuation at the first meeting little more than guesswork.
    
2. Second, there are lots of important deal terms beyond price that can significantly impact the valuation.  Setting a price without setting other important terms – for example, dividend preferences, board control, pay-to-play provisions, form of ant-dilution protection, liquidation preferences, etc.  Absent a common expectation on the many other material provisions of a particular term sheet, you can’t (rationally) set a firm valuation.  And surely, outside of the private placement world, a high impact investor can neither expect, or even want, to see a detailed term sheet as part of the first look at a deal.
    
3. Third, let’s face it: smart entrepreneurs (and investors) know that different investors, with different perceived value-adds, are likely to get different valuations.  If you have never had a discussion with an entrepreneur that went something like “look, it’s First Tier Venture Fund – better to have them in at $2.5 pre than Third Tier Venture Fund at $3.5 pre” well, you’ve probably never done a deal with a tier one venture investor.

In fairness, I understand why investors outside of the venture investing centers want to have some sort of understanding of an entrepreneur’s valuation expectation before spending too much time and energy evaluating a deal.  Absent some tangential interest like market or technology research, no investor wants to waste time working with an entrepreneur that ultimately has unrealistic valuation expectations.  But that issue can generally be solved without getting into specifics with a more general valuation Q&A than a hard number.   It’s fair enough, for example, to probe whether an entrepreneur is familiar and comfortable with (in the ultimate sense of willing to live with) current market conditions.  But asking an entrepreneur for a firm price at the outset is like asking someone what kind of engagement ring they have in mind on a first date.