How Venture Capitalists Value Your Business

A key consideration for a company seeking venture capital financing is the valuation of the business by the venture capitalist. The higher the valuation, the less "dilution" current shareholders will suffer with the issuance of stock to the venture capitalist.

As the saying goes, valuation

is an art, not a science. Venture capitalists basically analyze the existing financial condition of the company, the developmental stage of its products or services, and the company's prospects. They also consider the valuations of other comparable companies.

For example, if the average enterprise-software company is trading at 30 times earnings, the venture capitalist will use a discount of this price-earnings ratio to help value the private company it's considering for investment. Like most things, however, valuation is ultimately subject to negotiation and is ultimately subjective. If the company believes the venture capitalist's valuation is too low, it can attempt to negotiate a higher one — or just decline the investment.

Sometimes the gap between the company's desire for a high valuation and the venture capitalist's desire for a lower valuation can be bridged. The venture capitalist might agree on the higher valuation. And if certain projected milestones are not met — such as completion of the development of a product within a designated time period or achievement of designated sales projections — the venture capitalist would be entitled to additional stock without extra payment.

Ultimately, you shouldn't get hung up on small differences in valuation. After all, the investor is bringing needed cash to the table and hopefully the expertise to significantly grow the business.