As a consultant and mentor to startup companies, I work with the entrepreneurs on value creation, business model generation, and go-to-market plans. I also help them raise the money they need to build their companies.
At that stage, the question of valuation inevitably comes up. How to determine your startup’s valuation? This is an important factor in negotiating a successful investment deal. It has a significant effect on the current round of investment, as well as on subsequent rounds.
Numerous articles have been written about this subject, and plenty of spreadsheets and calculators have been created to help entrepreneurs determine their startup’s valuation. And yet, many entrepreneurs still struggle with this. In particular, first-time founders of early-stage startups.
Typically, early-stage startups have no products, no market traction, and as a result, no revenues. They may represent a great promise and opportunity, but also a huge risk. And yet, in order to raise money, they need to set a monetary value for their stock.
To be fair, setting a realistic value to an early-stage startup company is not trivial. Some say it’s more of an art than an exact science. Indeed, I would say that it is pure speculation. In other words, an educated guess. And moreover, at the end of the day, it comes down to a negotiated value for an investment deal. A value that enables you to raise the amount of money you need, without giving up more equity than you are ready to give.
Experienced investors and VCs have developed their own sophisticated tools, based on many investment deals, in order to reduce their risks and increase their ROIs. But, most entrepreneurs don’t have access to these tools, nor the time for extensive analyses.
So, I’ve developed a simple yet effective process that helps founders of early-stage startups determine what is the appropriate valuation for their company. It’s based on three basic factors.
First, you need to convince investors that you are “fundable”. I’ve written about this in a previous post. Investors in early-stage startups mainly look at three critical criteria. First and foremost, the quality and strength of the founding team. Second, the potential value of your idea. In other words, how big of a market are you targeting, and how strong is your value proposition? And lastly, your business model. Can this be a high-growth, scalable and profitable business?
If your startup is considered “unfundable” by your target investors, there is no point in attempting to raise money before you address their concerns.
1. How much money do you need to raise?
To begin with, you need to decide how much money you need to raise in this round of investment. In a previous post, I’ve written in detail about this topic. In short, it should be based on your next milestones and the actual work plan for the upcoming 12-18 months.
The money you raise should cover all of your estimated direct expenses, including salaries, capital expenses, services (i.e. legal, accounting, IT), travel expenses, and all other operating expenses.
In addition, I highly recommend adding some buffer to your estimates since entrepreneurs are by definition very optimistic people, and yet life has a way of disrupting even the best plans.
2. How much equity are you prepared to offer investors?
This is a tricky issue. Obviously, you want to give up the least amount of equity that you can, while still raising the money you need. However, that can be impacted by several factors. For example, the experience and previous successes of the founders, or the attractiveness of the target market. And, at the end of the day, it is also subject to negotiations.
Typically, in early-stage rounds (i.e. pre-seed, seed), investors expect to get anywhere between 15%-25% equity. But, I’ve also seen pre-seed investments with 35% and even 50% equity.
And yet, a high amount of equity doesn’t necessarily mean that you got a bad deal. It mostly depends on the quality of the investors. In one case that I’m familiar with, an investment firm got a 50% equity in a small pre-seed round. Today, that company is valued at over $1 billion. I don’t think the founders have any regrets about their decision to take that deal.
So, if you have a strong founding team, a very compelling value proposition, and an attractive business model, you can start with an offer of 15% equity in your pre-seed round.
3. What was the recent valuation of similar startups to yours?
This is a very important reference. And yet, this data is not easy to obtain. You can talk with fellow entrepreneurs who have recently raised money. You can also check with VCs that you know and trust. VCs usually know the investment deals in their markets. It is their job to have this information.
Ideally, you should look for investment deals in your specific domain, e.g. cybersecurity, fintech, advertising, etc. And, for companies at a similar stage as yours. There is no point in looking at startups who are in totally different fields or stages.
For example, recent US studies published by the Angel Capital Association in the “Angel Funders Report”, show that in 2018, 45% of pre-seed startups raised money at valuations of $2.5M – $4.5M, and 47% of seed startups were valued between $4.5M to $8M.
However, it is important to note that valuations can vary significantly even in the same market and stage. It’s a matter of investors’ perception and speculation, both of which are totally subjective.
A simple example
So, let’s assume that your next significant milestone is to complete the development of your MVP. And, your detailed work plan shows that to do that within the next 12-18 months, you need to raise $1.5M.
In addition, you are ready to give investors, in this pre-seed round, 20% equity in your company.
Hence, your pre-money valuation will be $6M.
In summary, determining your startup’s valuation is important in order to negotiate a successful investment deal. And yet, it’s merely a tool, not the goal in itself. Entrepreneurs should not obsess over it, or try to over-optimize it.
To quote Geoff Ralston of Y Combinator, “The objective is to find a valuation with which you are comfortable, that will allow you to raise the amount you need to achieve your goals with acceptable dilution, and that investors will find reasonable and attractive enough to write you a check.”