Are early stage startup valuations determined at random?

To many, it seems like early stage startup valuations are determined at random. Given that these companies often fetch higher valuations vs. their counterparts in other industries — despite lack of significant revenue, hard assets, or even direct public companies to evaluate them against — this misconception is understandable.

But of course valuations are not generated at random, and there is some method to this madness. Below are four key factors that VCs take into account, both consciously and subconsciously, in determining a “fair” valuation for startups they are looking at.

Ownership Targets

Unless you are raising a party round where everyone is chipping in due to FOMO or option value, experienced investors may determine your valuation based on their loose calculations as to how much ownership they may need in your future exit to “move the needle” vs. the rest of their portfolio.

At the same time, smart investors also keep an eye on the cap table to make sure it won’t be a cause of misalignment down the line, negatively impacting founder motivation for generating long-term investor value.

Supply and Demand

We all learned in econ 101 that in an efficient market, supply and demand is the key determinant of price. But does this apply to the startup world?

At the micro level, if multiple investors are competing for a deal, offering startups attractive valuations is one way investors may distinguish themselves. In addition, startups with high investor demand often times are able to raise more money. This in itself can create a higher valuation.

On the macro level, a startup’s valuation is influenced by the supply and demand of capital within that startup’s industry and geography. For example, if you are located in Silicon Valley and working on a Fintech startup, chances are good that you will have a higher valuation than a medical device startup in Israel. This has to do with the different expected returns and cash flow requirements between these industries and geographies, and also with the supply of capital chasing startups in these sectors.

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Deal Terms 

There is a famous angel investor who, when determining valuations, tells startups: “name your price and I’ll name my terms.” Smart investors calculate valuation differently than most founders, as they take into account factors such as ESOP, warrants, pro-rata rights, and liquidation preferences when determining expected outcomes. I won’t go in-depth on this subject as it’s covered in detail elsewhere, but the point is that price is one of many factors that determine actual valuation.

Investor Conviction 

What about predictors of startup success, such as quality of team, market opportunity, and traction? These are all factors that influence an investor’s decision of whether to invest in a startup. However, they don’t impact valuations beyond the fact that investors may be more flexible on valuations in opportunities they are especially excited about. All investors have at one time or another “overpaid” to invest in a company they really believed in, or walked away from others they believed were overvalued.

At the end of the day, your valuation is whatever someone else is willing to pay. Think of the above four factors (investor ownership targets, supply and demand, deal terms, and investor conviction) as levers to use in your negotiation to determine a “fair” valuation for your early stage startup.

Jonathan Friedman is a partner at LionBird, a digital health investor active in Israel and Chicago, and blogs about the Venture Capital Point of View at VCPOV.com.