Strong Opinions @marksbirch

Random thoughts from a NYC entrepreneur and investor about start-ups, technology and the people that make it all happen. Also find time for good tunes and good food.
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It is the eternal startup question; what is the value of my company?  Later stage startups have revenue numbers, customer acquisition costs and marketing analyses that can all be plugged into magic financial formulae by VC whiz kids that pop out instant valuations.  On the other hand, early stage startups have none of that.  Most of the time, establishing valuation ends up being a crap shoot.

Many startups are holding off on setting valuation in favor of convertible debt (Fred Wilson has a good recent write-up on this).  It is generally faster and cheaper to complete these rounds as the terms are straightforward.  It also makes sense as the concept is in such a state of flux, the likelihood of pivoting makes setting a valuation especially difficult.

However, there are many cases when establishing valuation upfront does make sense.  Even though convertible debt has grown in popularity, many investors still prefer equity because they know upfront how much of the company they will own.  Another point to consider is that the cost of equity rounds has come down significantly, and some lawyers will be able to get the process completed inexpensively using standard documents (just make sure to get credible references however, undoing poor documentation is a nightmare).

If you are an early stage startup founder racking your brain on setting the proper valuation for your seed round funding (or even Series A), here are some factors to consider:

  • Geography – Where you are located will strongly influence your ability to raise cash.  Outside of San Francisco, Boston, New York and a few other tech hubs, the ability to raise capital is going to be significantly harder due to the lack of available investors.  Another factor is what types of deals get done in which location.  For example, B2B plays well with Boston investors but not so well in New York whereas the reverse holds true for consumer tech.
  • Sector – Some sectors of the tech industry are hot.  Everyone is trying to be the next big social network, location-based deals application or casual games platform, and a lot of investors are clamoring to get into these deals.  On the other hand, enterprise tech and hardware are not so hot.  It does not mean that they cannot get funded, it simply means the pool of interested investors is smaller.
  • Stage – How early are you?  If you simply have an idea, your likelihood of raising cash is nil.  However, if you have a working product, revenue and customers, then you are pretty far along and probably more in need of Series A funding.  Your sweet spot for fund raising success is having at least an initial release of the product and a small team in place.
  • Traction – How quickly are you growing and what significant milestones have you reached?  This speaks to execution ability.  If you are crushing it with customer acquisition, signing deals and partnerships, etc., then you have more proof points to convince investors that you are a worthwhile investment.  If you are going the slow burn approach, where you are growing but not by leaps and bounds, then you may not be able to command a premium on valuation.
  • Market – How big is the market and revenue potential?  If you are diving into a rather narrow niche, you are going to limit your potential market and your startup may not be as attractive to investors looking for big returns.  For example, most mobile apps only apply to a small audience and revenue upside is negligible.  If you have a broader market or a small market coupled with big ticket sales, that opportunity is of more interest to investors.
  • Barriers – What are the barriers to entry for your startup, and conversely, how defensible is your startup?  If you have a patent for your product, you already have a strong, defensible market position.  If there are currently regulations that limit your market, you are in a weaker position.  You should evaluate all barriers against your startup and barriers that can protect your startup and use the results to influence your valuation decision.
  • Social Proof – What other investors are on board?  It helps if you have an early investor that is committed to your round, and even better if it is a well-known investor.  Chances are a more established investor will set the terms and valuation for you, particularly if the investor agrees to lead the round.  Of course, you should negotiate, but most likely you will settle around the number that is presented.  It is better to get a well-known and credible lead investor at this stage than risk passing and looking for other potential leads.  One caveat is if you have multiple investors involved early, then you obviously have more pricing power, just don’t overplay your hand.
  • Incubators – The attention of Y-Combinator and TechStars has had a significant impact on valuations.  They have become the Ivy League of startup programs, and graduating is an almost sure ticket to funding, as much as a Wharton MBA is a sure ticket to a top banking job.  There are plenty of other incubators and accelerators popping up around the globe, and if you went through a particularly well-regarded program, you can command a healthy bump on valuation.
  • Comparables – Using the real estate industry method of determining housing values of similar properties, you can take the same approach in setting valuation by checking out AngelList, Crunchbase and Chubbybrain.  You can see how similar companies in your sector are being valued and how recently they closed their round.  Of course you will need to adjust based on your traction, stage and other factors, but at least this gives you a scale of valuations.
  • Capital Raise – The amount of money you are raising plays a large part in setting valuation.  If you are only looking to raise $500K or less, your valuation should probably not be $5M.  This is where comparables can help in determining a reasonable range.  A general rule of thumb would be setting pre-money valuation at 4x the amount you are raising.  Thus $500K raise would be $2M pre-money, and $1M would be $4M pre-money.  You can then apply a discount or premium based on the other factors listed here.  Note that if you are raising less than $500K, you are most likely pre-product launch and would be better off using a convertible note.
  • Funding Environment – The above is only a very rough guide, and at the moment the market is seeing more inflated deals with pre-money valuations set upwards of 6-10x and above capital raised.  Whether this is healthy or not, you need to be aware of the current state of funding.  In lean years, valuations were suppressed, but as more investors enter the startup ecosystem, expect valuations to continue to rise steadily.
  • Future Rounds – While not as important as the other factors above, setting a valuation that is too high or too low will impact the future value of your equity stake.  For example, a too high valuation can be problematic for future funding rounds if you cannot increase valuation by an appreciable amount.  Again this is a minor point however; your focus should be on closing your round and getting back to building your startup.
  • Pedigree – If you have started and sold one or more startups at a decent return, then you can probably set your valuation at whatever you like (see Path, Color, et al.).  The same holds true for the earliest employees at top startups, CEO’s (or top senior managers) of well-established technology firms, former VC employees and well-connected entrepreneur technologists.  They all have direct lines to VC partners and well-known angel investors, plus an established track record of execution at a high level.

This is only a general guide on early stage valuation.  At the end of the day, setting valuation is a bet that you are making at a high stakes table where you are inviting investors to play.  It is a gut feel decision, but using the above criteria can at least clear up your thinking and put you in the right ballpark that is fair for you and gets investors in the door.

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