Writing here as a Silicon Valley VC, I’m going to spill the beans on how valuation is really determined in practice. Quite simply put: “Valuation is a function of negotiating leverage and target amount of capital that a VC wants to invest — particularly for early-stage companies.” 1) In general terms, VCs target 20-30%+ ownership of a company. Why? It all boils down to ownership structure — VCs can’t take too much ownership of a startup, otherwise there’s not much incentive for the entrepreneurs to build something large. At the same time, VCs can’t take too little ownership, or else even a healthy exit of, say, a $200M acquisition doesn’t move the needle for the VC’s fund of $200-300M+. The typical baseline is that for a classic Series A, VCs will take 50% of the company. 2 VCs syndicating a deal (which is often a wise structure to allow for more pockets of $ around the table — especially important should the company need additional insider financing to get to the proper milestones to drive an increased valuation for the next outsider-priced round of funding) will want 25% each, and also call for an option pool of 20% or so to be created, leaving the founders with ~30% ownership. 2) Given the typical 50/50 split, the baseline expected amounts to “pre-money valuation = target amount to be raised” (e.g. $5M raise on $5M pre, $20M raise on $20M pre). This is where both negotiating leverage and the dirty secret of the VC industry kicks in… 3) Leverage is determined by how hot the deal is (e.g. how many VCs fighting to get into the deal), and how badly the company needs money. This is an odd one though, as it’s somewhat chicken and egg — as soon as a desperate startup that’s about to fold gets a term sheet from a “name brand” VC, all the other lemmings pop out of the wood work and start their mad frenzy to get into the deal, often resulting in a bidding war as each new would-be party crasher proposes a higher and higher pre-money valuation (e.g. going from “$5M raise on $5M pre” to $5M raise on $10M pre”). On the other hand, if the deal is regarded as “picked over” by all the VCs who have taken a look and passed, a VC who wants the deal can likely win the deal at an extremely punitive pre-money valuation, and even swing the ownership structure to 60%+ ownership for the VCs (e.g. $5M raise on $2.5M pre). 4) So here’s the wacky part: if you’ve been following along, you may have been thinking to yourself, “wait a minute — if pre-money valuation is pretty much tied to amount raised, then who determines the proper amount of capital to be raised?” Enter the screwed up dynamics of the VC industry, which has been suffering from a state of capital overhang — or in other words, “too much darned $ invested into VC funds since the bubble days!” Often, startups may only need, say, $5M to get to the milestones needed to raise the next round of funding at a markup in valuation. However, if a $500M-$1B fund needs to deploy $10-15M a shot per deal due to the large size of the fund, then the VCs will likely inflate the amount to be raised…and thus raising the pre-money valuation in the process. (And what entrepreneur would turn down more money offered to him or her at pretty much the same ownership dilution?) Strange, eh? Valuation in many cases therefore has nothing to do with inherent “value” of the company or operational achievements made to date — like the cause for all wars and pretty much the story of the human race, it’s pretty much “all about the Benjamins” as the rappers say. 
[Note — one subtle dynamic that most entrepreneurs don’t realize upfront when increasingly large bags of $ are being dangled in front of them: yes, it’s very tempting to take more money at the same ownership structure as a deal with a smaller amount of $ raised. However, the key to valuation is thinking about POST-money valuation, and not pre-money. Think of post-money valuation (which equals pre-money valuation + amount to be raised + any additional warrants or post-round option pool increases) as the hurdle you set for yourself to clear as the minimum pre-money valuation you need to get to for the next round. Case in point: you’re raising your Series A, and you need $5M to build the product and get to the first $1M in revenue. You’re playing in a reasonably hot space that’s starting to get some buzz, so you get your first term sheet for $5M on $5M. Word gets out, and other VCs start doing drive-by diligence and lobbing in their competing offers. Next thing you know, you’re staring at a $10M raise on a $15M pre! Fantastic, right? Higher pre-money valuation, more money in the bank, and even less dilution than the first offer! The unspoken risk, however, is that you’ve now set the bar for Series B pre-money valuation at a floor of $25M just to get a flat-round valuation. And since you’re gunning for increased valuations over the previous round post-money valuation to minimize dilution, what that really means is that you need to hit a $35-40M+ pre-money valuation for Series B to minimize dilution to your stake. Let’s say the $5M would’ve taken you to $1M in initial revenue, and with most VCs wanting to invest $5-10M per round, it’d be the perfect sweet spot for a Series B of, say, a $15M raise on $20M+ pre — a reasonable markup from the Series A post-money of $10M. However, it’s likely the additional $5M raised in a $10M Series A funding would take you to perhaps $2-3M in revenue — a point highly unlikely to earn you a $40M premoney (unless your space in general is the hot fad of the moment). The bottom line: there is no free lunch, and the illusion of a higher pre-money valuation accompanied by an inappropriately large amount of capital raised often results in an unpractically high post-money to overcome for the next round of funding. The fortune-cookie version of this takeaway is the following: “Confucious say fixating on pre-money is like standing too close to work of art — missing bigger picture! Only post-money matters.”] (man, I hope I don’t get whacked for revealing the secret!)