Valuation – the monetary value of a company – is the source of much worry on the part of the typical entrepreneur. But it need not be such a tremendous stressor. Certainly, valuation matters, but, for early-stage startups, it is much less a reflection of intrinsic value or accomplishment and much more a product of market and other factors. Moreover, for new ventures, valuation is an art, not a science.
I have not previously written about startup valuations, because I presumed everything that could be written about them probably already had been. At some level that may be true, but a few Google searches turned up a number of “methods” of varying levels of complication, nearly all of which are, in my view, bunk. One that I thought was reasonably helpful was this one by Seedcamp. I’ll attempt in this post to lay out my observations on early-stage valuations based on my more than 15 years as an early-stage investor.
First, a couple of caveats. This post is for founders and management team members of early-stage startups; companies that operate in pursuit of very rapid growth in large markets by leveraging technological and/or business model innovation. These observations are not relevant for other kinds of (more typical) businesses.
Second, a couple of definitions. Pre-money valuation is the value of a company immediately before it takes in fresh capital from investors. Post-money valuation is the value of a company as it closes a new round of financing, and therefore includes the amount raised in the funding.
I’ve written that early-stage valuations are more art than science. Art is necessary because companies at this stage have no profits (earnings) and little or, at best, unpredictable revenue. These measures are necessary for the application of typical valuation methods, such as the discounted cash flow or comparables analysis. At some level, then, such valuations are not “fundamental analyses.”
The only true measure of value – one might argue in general but certainly for such hard-to-price assets as young startups – is market value: what a buyer will pay and a seller (the shareholders) will accept.
Market value, in this case, is the valuation at which investors will invest. This price is influenced by market demand (e.g. how much capital is available to the company relative to the amount it chooses to raise). The price is also influenced by the ownership targets of investors. Most professional investors have an ownership target – a percentage of fully-diluted equity of a company that they like to own after making a new investment. They also have a preferred check size, or target amount of money they want to invest. These two numbers – target ownership and check size – have a huge influence on valuation: an investor that wants to own at least 10% and likes to invest $100,000 per deal will seek post-money valuations of $1 million (or less).
Of course, amateur investors – those that do not invest as a primary use of their time as a money-making exercise – can set valuations as well, in the absence of participation by professionals in a particular financing. Founders should avoid setting a valuation for their companies with amateur investors. It is nonetheless common for founders to raise capital from amateurs – friends and family – before raising from professionals. In such cases, founders should use funding instruments such as convertible notes and safes to avoid setting a valuation (and to minimize legal expenses associated with the fundraise). These instruments effectively postpone the valuation exercise to a future round of financing.
Still, a founder reading this might be wondering, how do I know if I’m getting a fair deal? One concept to keep in mind is one my former partner, Ross Goldstein, refers to as the “Goldilocks Principle”: you want a valuation that is not too high and not too low. A valuation that is too low is easy to recognize, because it leaves founders with too little equity to remain motivated to sacrifice for the company, particularly taking into account dilution from future financings. There is such a thing as a post-money valuation that is too high as well; it is one that the company cannot reasonably surpass by the time it raises its next financing round, based on realistic expectations of progress in between.
As of this writing, I have recently observed pre-money valuations in the ranges listed below based on financings led by professional investors. Of course, the specific circumstances of a given company and financing can lead to very different numbers:
- Pre-product: $0.5-2 million
- Live product, pre-revenue: $2-4 million
- Up to $1M ARR (good growth and unit economics): $4-8 million
- >$1M ARR: $8 million+ depending on amount and growth of revenue
As you’ve gathered by now if you’ve read this far, early-stage valuations are not personal judgments of the management team, nor are they a particularly useful measure of progress or accomplishment. These observations are important for founders to remember; if you internalize this reality, you may find you are less anxious about the number you ultimately settle on for the first valuation of your company.
