Answer by Patrick Mathieson, VC at Toba Capital, on Quora,

Valuation is merely what buyers and sellers agree that a company is worth. Pick any publicly traded stock and look at its market capitalization--that's the equilibrium point, at least for the moment. Think of it as a negotiation that occurs hundreds of times each minute, between thousands of buyers and sellers.

For startups and other privately-held corporations, valuation is determined in the exact same way, except the number of participants in the negotiation is far less. Often it's just the founders and majority shareholders (often the same people) of the startup, and one or more groups of investors. The sellers (the existing shareholders) try to get as high of a price as possible, and the buyers (the potential investors) try to lower the price as much as they can. If the two parties can agree on a valuation, a deal can be struck. If they cannot, they won't do business.

Just as in any negotiation, each party's ability to force a beneficial outcome is based on their:

  • Willingness to buy (or sell)
  • Willingness to walk away from the deal

So: if you're a founder and you want to dilute your holdings as little as possible, you must do a good job of convincing investors that your company is valuable (read: increase their willingess to pay). And you must be willing to walk away from the deal if the terms aren't good enough.

I'm a little confused by the article that was included in the question comments. The Google/YouTube deal was a great outcome for both the founders (who made $100-200M each at the time in Google stock, which now is worth something like a billion dollars), for Google, and for the investors. Without the investors' money across multiple rounds, YouTube wouldn't have been able to execute well enough to command the $1.65B price that Google eventually paid for them. Those financing arrangements with VCs were sought after by the entrepreneurs, who fully understood what it meant to give away equity in exchange for cash. Are you trying to avoid a situation where your VCs can make 41x returns from their investment? Trust me: if that ever happens to your company, your bank account will end up just fine.

If you'd like to reduce dilution as much as possible, you need to keep the valuation high (see my previous paragraphs) while also taking less money from investors. The best entrepreneurs have a clear and defined strategy for balancing dilution and growth (because cash from VCs should lead to faster growth in the business) in a way that maximizes value for all of their shareholders.

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Published on: Nov 28, 2014