How to set a valuation for your early stage startup

Early-stage valuation in tech startups which are potentially very high growth startups, is more an art rather than a science, but the influencing factors are as follows:

Reputation of the Founder

Experience applicable to the business, entrepreneurial success

Value in the business to-date

Capital (arguably including sweat equity) invested by founders, or other tangible value e.g. userbase, agreed distribution channel or amazing IP.

Traction

WoW or MoM growth rate of revenue or a proxy for revenue, e.g. users.

Market forces

What’s typical in the market at time of raise (e.g. valuations are obviously lower in a recession than when in an economic boom or valuation bubble).

Location

Silicon Valley valuations are usually higher than Europe or sometimes even in the UK, for example.

Fashion

At the time of writing Artificial Intelligence is fashionable, tomorrow it will be something else which is “hot”.

Hotness

How many investors want to invest.

Not the same as fashion, because Founders who are naturally great sales people can create a feeding frenzy even for not-fashionable sectors.

Hotness is actually a function of all the above and below, but probably the most powerful.

Maths and motivation

All are pretty obvious except this last one.

The maths is because while it might seem backwards, valuation partially depends on how much money you need to achieve your next milestone. i.e. a bio-tech hardware company will need many more times the capital than a SaaS platform, yet it doesn’t mean they’ll give away 10 times the equity at the start.

The motivation is linked very much to the maths. That’s because smart investors recognise that Founders have a long journey ahead and that while they will inevitably likely lose majority share holding control of the business in some future growth funding round (e.g. Series-B or beyond), they will need to retain a high level of motivation to continue.

If then a greedy angel investor(s) takes 30 or 40% of total ownership in your startup in it’s first funding first round, then after multiple rounds of subsequent funding, the Founders are going to fast not only lose control but be less motivated than they could be, because they might not own an equity % which represents a life changing amount of money at exit.

At time of writing (2016) most companies I see are valued between $1m (£900k) and $2.5m (£2m) pre-money for first money in; first money usually being a £150-£500k cheque. But this depends on all the variables above, AND of course as noted earlier, the total round size (biotech needs more money than most B2B Saas). Having said all this, I’ve seen many startups outside of these numbers too — and that doesn’t make them necessarily wrong to raise at the valuations they do.

Often the companies are pre-revenue, sometimes pre-product too; so there’s no obvious profit, sales, ARR or MRR to multiple to justify X valuation.

This is why valuation is more an art than science.

If you raise a convertible note or SAFE then the CAP on the notes are often between $5m-$10m with a 20–30% discount; which could mean when the note converts the Angel round was significantly more expensive than the typical UK equity funding round previously described.

Many companies rightly get further along (because creating software is so much cheaper and easier than it used to be) and when they are solving a painful problem with scalable technology and have a big vision, often even the first money in can be at a significantly higher valuation than above.

In Summary

For traditional business angels, used to investing in businesses on which they are expecting only a 2–10x return (and which may sell for 2x revenue or 4–10x profit)

i.e. Businesses which are never going to be high growth in comparison to a winner-takes-all transformational tech business which can use network effect, viral growth and/or low distribution costs and the global access which the Internet allows, to grow disproportionately quickly.

..the valuations of tech startups often seem baffling. You only have to watch Dragons Den (or Shark Tank in the USA) to see the difference between potential high growth tech startups and what I’d prefer were called entrepreneurial businesses.

There are many great articles out there on the pros and cons of valuing your business as a Founder too high or too low, and it’s often also true that the other details of the deal are far more important than simply the valuation — so do get Googling if you want to learn more. Seedcamp have a good blog on the subject here.

For businesses with more traction or revenues, there are more scientific ways to give a valuation context. Update: Tomasz Tunguz from Redpoint did a good post here, summarising the important of growth rate in relation to valuation sought.

To those friends — and traditional investors — whom I’ve been asked to explain why a tech startup company can be worth >£1m when it has no paying customers and a version one product, or to Founders as to how they should set a valuation on their new enterprise, hopefully this sheds some high-level light.