I recently had coffee with a startup founder (let’s call him Ben) that has been working at his startup for the past year or so. His vision for his product and company had developed quite nicely since we first met, when his concept wasn’t much more than some rough sketches and guesses at what it could be come. In the past year, Ben and his partner had bootstrapped their way to launching an MVP and signing up some initial Beta customers. He’s now at the point where he’s fine tuning his product to understand if it’s really serving his customers right. While the venture has been self-funded to this point, Ben plans on soon talking to investors in anticipation of later raising seed capital.
There’s just one problem: Ben has no idea how to value his company.
This is a common conundrum for Founders. On one hand, how can anybody possibly place a value on something that really doesn’t exist yet — especially if your startup is pre-launch / pre-revenue? On the other hand, you have to put a value on it. If an investor is going to fork over cash, they have to know what they’re actually getting in return. You can raise via a convertible note and avoid the valuation conversation, but even then you still sort of have to cover it. (More on this later).
In more nascent startup communities like Cleveland, Ohio — where Ben and I both live — it’s especially difficult. There aren’t as many similar startup companies in the area that investors can compare you to. It’s hard to gauge what’s “normal.”
Admittedly, I’m not going to offer up a magical formula in this post that will bring complete clarity to the issue of setting seed-stage valuations. But here are a few factors to consider:
Who you’re pitching matters.
When you’re pitching your startup to a professional angel investor vs. friends-and-family vs. seed-stage venture capital firm vs. angel group, they all may have a different take on what your valuation should be. One way to get a gauge on what they might expect is to take a look at the startups that they’ve invested in recently — particularly those that are located nearby, and are in a somewhat similar space. For instance, if an angel group you’re pitching recently invested in a company that manufactures physical products, you shouldn’t expect your internet company to receive a similar valuation.
Also, remember that whoever the investor is, they’re trying to make a return. Investors are all different — some like to take big swings and are hoping to hit a homerun and make a 50x return, but know that the overwhelming majority of their “swings” will be misses. Many of the investors in my local community are perfectly OK with some doubles and singles — and hope to make 7-10x return. So work backwards a bit. When you’ve thought about your business model and the future of your company, how valuable do you see your company being in 5-7 years? Do you see it being a company worth $50 Million? If so, that big-swing investor probably won’t be interested in you anyway. Even if they were, they would have no incentive to value your startup for anything more than $1 Million.
Your location matters.
The harsh reality is that valuations are going to be drastically different for a Cleveland-based startup that is raising seed capital for the first time compared to a startup with similar traction in a place like San Francisco or New York. There are a few reasons for this. First, remember that seed-stage investors tend to be proximity-based investors. It’s certainly not an absolute. After all, one of eFuneral’s original investors came from Albuquerque, New Mexico. But knowing that it’s more common for investors to invest near where they are, investors face much more competition from other investors. This drives the valuation up, as really — just like anything else — a startup is worth what the market will bear and competition drives up market value. In Cleveland, there are fewer startups to fund. While location doesn’t necessarily have any bearing on whether or not the company will be successful, it does impact the startup valuation. Two VC’s that I interviewed for Startup Seed Funding for the Rest of Us freely admitted that one benefit to investing in startups outside of Silicon Valley was that they would be able to negotiate a lower valuation.
Are there exceptions to this? Of course. The quality of the team can especially drive the valuation up a bit. For instance, if the entire startup team has PhD’s in Computer Science from Case Western Reserve University or Carnegie Mellon University — they will likely catch the attention of investors in Cleveland and Pittsburgh (or anywhere, frankly) and those investors could be willing to pay more than another startup team. Same goes for startups with founders who have successfully built and sold companies in the past.
Timing is everything
The stage of your startup can be a major factor on the valuation your company receives. If your company has great traction — double-digit monthly growth in revenue, registered users, or whatever metric is important to you for several months in a row — investors will certainly perk up.
But let’s face it. Most of the time, founders are raising when their product hasn’t even seen the light of day. They’re still in Beta (or Alpha… or worse), and really don’t have any proof points to show yet. Believe it or not, that’s perfectly OK. In fact, for eFuneral, I found that the best time for us to raise was in the couple of months before we actually launched. We had a prototype — and could clearly demonstrate how that prototype was becoming a real, live product. We weren’t live yet, though — meaning that nobody really knew what it could or would become. Because of this, there was still a belief that it can be something very, very big.
Once we launched — investors took more of a “wait and see” approach to determine whether we could actually achieve our business goals. What I learned is that the longer you wait after launch, the more likely that valuation will be a factor of what your business is right now vs. what it can be in the future. If you’ve launched and you’re doing “just OK” — investors are likely to not issue a high valuation because their belief is that your potential may not be that much higher than what your business is today. Of course, if you’re demonstrating exponential growth — that’s a different story.
Valuation considerations when you’re raising via a Convertible Note vs. Equity
As I mentioned earlier, one way to avoid the valuation conversation is to use a convertible note — which is essentially a loan that converts into equity when the startup raises a future round of financing. With a convertible note, there is no valuation. Instead, the actual valuation is set by that future round of financing. There is, however, a valuation cap — which is a limit that caps the valuation that this specific investor will assign to your startup. For instance, if your convertible note has a valuation cap of $10 Million — and the next time you raise a financing round, your new investors value your company at $20 Million — your convertible note holder’s equity will convert at a $10 Million valuation — not $20 Million. It’s possible that the valuation of your actual financing could be less than the valuation cap — let’s say it’s $5 Million. In that case, the convertible note holder’s equity would convert at a $5 Million valuation.
A valuation and a valuation cap are two different things. But many investors treat these very similarly in that they still are trying to determine what the valuation of your company will be. So if your goal is to avoid the valuation conversation, you should know that it might not be possible.
OK, Mike. But really — how should I value my company??
In the end, valuation is more art than science. There is no magical formula — and unfortunately, there really aren’t any great tools online that will help you find the right number. I love AngelList — and they have an interesting tool to help you calculate seed stage valuations in your area (or by other filters). But I can tell you with certainty that the average seed stage startup in Cleveland is not getting a $3M valuation. Some certainly do (or even more, based on the quality of the team or the uniqueness of their product). I know first-hand that the angel groups in the area will generally not invest in a seed-stage startup that’s looking for more than a $1.5M valuation.
The best way to really determine the right valuation for your startup is to talk to as many founders as you can — both in your area, and that operate similar businesses. You’ll get a sense for what your “normal” is. If there aren’t as many startups in your area, talk to founders in areas that have similar characteristics as yours. For instance, if your Cleveland-based startup is trying to set a valuation, you could try to network with founders in Pittsburgh, Columbus, or Detroit instead of more mature startup markets like Silicon Valley or New York.
Realize that in the end, 0% of nothing is still nothing.
Here’s the reality: it really doesn’t matter whether your seed-stage startup is valued at $1.5M or $2.5M. What matters is getting the resources you need and finding the right investors. Don’t make decisions on which investors to work with purely based on investment. What’s more important is finding the investors that can help you grow your business. This way, the next time you raise — you’re not raising at double your current valuation. You’re raising at 10x that valuation. And if you are able to convince investors that your business should be valued at, say $1 Million — don’t second guess yourself and worry about the extra equity you could have saved if it was $1.5 Million. Despite what your startup is valued on paper, none of that really matters until you’re able to build real value in your business. Focus on doing just that.