SUB CATEGORIES OF Funding Your Startup

Seed capital is a startup’s initial capital. Startups raise seed capital at valuations based on market norms and qualitative and some quantitative factors. Seed investors rarely find discounted cash flows based on pro forma financials to be particularly useful. Financial projections, regardless of the source, are simply too imprecise and do not correlate with actual results for reliable analysis. In our view, startup valuations are more an art than a science.

The most common method for startup valuations is comparable transactions or market norms. Services, such as Halo Report, publish quarterly valuation statistics for angel investments. AngelList also has valuation data sortable by type of company and other metrics. For better or worse, a startup’s valuation is influenced by its sector and focus. If the startup is in a hot sector, its valuation will be higher. Conversely, a startup in a weaker sector will have a lower valuation.

A startup should use multiple methodologies in computing its valuation because those methodologies will help it argue for a higher valuation with investors. The most important seed investment term to negotiate by startups and angel investors is valuation — valuation will most influence the potential returns of the founders and seed investors.

At a seed stage, most startups are worth close to zero, but valuations are clearly much higher than zero. The unwritten rule is that angels will invest in a startup at a valuation that allows the founders to continue to control the startup. Without the founders’ efforts, the startup will fail, which means the founders need to have a strong incentive to make the startup successful. Because founders will be further diluted in the next financing round, seed investors usually receive no more than a 25% interest in a startup in the aggregate (and more often 10% to 20%).

Factors that Affect Valuation
Team

  • A rockstar team comprised of founders who have had significant prior exits will be able to raise capital at higher valuations. The team is the most important factor if the founders are rockstars in the tech community. For example, if Mark Zuckerberg decided to raise capital for a new business, regardless of the idea, he would have investors lining up and willing to invest at very high valuations.

Traction

  • Traction has a direct correlation to valuation and an even stronger correlation with likelihood of being funded. Every fundable startup is formed to get users, sell advertising, generate revenue and profits or some other metric. The greater and faster the growth and traction, the higher the valuation. Rocketships like Tumblr received very high valuations based on their user growth.

Revenues Strong startups seeking seed funding usually do not have bona fide revenue, so revenue is not a real factor for seed valuations. If a startup seeking seed funding has bona fide revenue, it could be a negative sign because the startup should be well beyond its seed stage when it has bona fide revenue. Startups become valuable because they grow quickly (see “Traction,” above). If a startup is not growing quickly enough, it will not be deemed valuable by investors.

Customers or Exclusive Suppliers. Startups which have entered into agreements with prominent third parties, whether customers or vendors, could argue for higher valuations. These are not, however, the most important factors.

Sector. Investors are lemmings. If the startup’s sector is hot, it will receive a higher valuation because there will be more investor interest. Economics 101 says that as demand increases, prices increase. Startup valuations follow the same basic economic rules.Geography. Startups in tech communities, such as the San Francisco Bay Area and Seattle, receive higher valuations on average than startups located outside the established tech hubs. A startup in Palo Alto California might receive a two to three times higher valuation than a similar startup located in Denver Colorado. The same startup located in Laramie Wyoming is probably unfundable.

 

Analytical Valuation Methodologies

Percentage Ownership Method. As discussed above, seed investors typically own between 10% and 20% of a startup. One simple method to compute valuation is to divide the amount seed investors are willing to invest or the targeted amount to be raised by .10 to .20 and the result is the post-financing valuation.

Scorecard Method. A method developed by Bill Payne. Here is a link [http://billpayne.com/wp-content/uploads/2011/01/Scorecard-Valuation-Methodology-Jan111.pdf]. The Scorecard Method compares a startup to a typical angel-funded startup in the same geographic region and adjust the valuation based on the following weighted factors:

  • Strength of the Management Team 0-30%
  • Size of the Opportunity 0-25%
  • Product/Technology 0-15%
  • Competitive Environment 0-10%
  • Marketing/Sales Channels/Partnerships 0-10%
  • Need for Additional Investment 0 – 5%
  • Other – 5%

Venture Capital Method. The valuation is calculated by estimating the exit valuation and then discounting the exit value by the expected IRR over the time period to exit (average IPO is currently 10 to 11 years). This method is very difficult to apply to seed-stage startups because the numbers are conjecture and WAGS (wild ass guesses!). Thus, this is not the best valuation method for a seed-stage startup.

Dave Berkus Method. His method is applicable (in his view) to startups that could have annual revenue higher than $20 million within five years. Such a startup’s seed value is based on five factors:

  • Sound Idea (basic value, product risk) $1/2 million
  • Prototype (reducing technology risk) $1/2 million
  • Quality Management Team (reducing execution risk) $1/2 million
  • Strategic relationships (reducing market risk and competitive risk) $1/2 million
  • Product Rollout or Sales (reducing financial or production risk) $1/2 million

He views these numbers as maximums, which means his maximum pre-money valuation is $2.5 million (which is an average angel valuation). If a startup is good and not great for a particular factor, it might be worthy of $250,000 for such factor.