How valuations are really determined at the seed stage?

Valuation is a nebulous topic amongst early stage startups, so I thought I’d really spell it out in detail.

In short: Valuations for seed stage companies are fairly arbitrary and driven solely by supply and demand.  Supply – amount of your round and Demand – investor demand.

Your startup’s valuation is not based on a proforma of your revenue.  And therefore, it’s also not quite analogous to the market cap of a publicly traded company.  This is really key to understand because so many founders wonder, “Why was that company over there who has 0 revenue able to raise their round at a $10m cap convertible note?  And another company that is on a $1m runrate barely able to raise at a $6m cap convertible note?”

Because valuation is based on supply and demand, these are the levers that affect your valuation:

• Market / economic conditions
  • Geography
• Competitive landscape of your vertical
• Compelling components of your business (revenue / team / growth / performance)
• How you run your fundraising process

Market conditions

Unfortunately, market conditions are completely out of your control.  2008-2009 was a terrible time to raise money.  Many startup investors sat on the sidelines.  So, there were significantly fewer active investors at that time, which meant that valuations were really depressed.  I know an investor who got into Instagram’s early seed round at this time at $2m valuation, and this was considered to be a high valuation for that time period.  By the time 2011 rolled around, uncapped notes were quite common.

The reality is that external market conditions actually affect your valuation a lot more than what you’re actually doing in your business.  Because no one actually knows the right number to value your business, seed startups are very commonly valued around the same amount regardless of what is actually happening at a given company.

Additionally, geography matters a lot as well.  Startups who raise in the Silicon Valley can typically raise money at higher valuations than in many other places, simply because there are more investors here.  On the flip side, if there are only 5 seed investors in your town, they can pretty much command whatever terms they want.  This is changing a bit because startups are starting to raise money outside of their hometowns, and there have been huge increases in the number of investors in many places (NYC is a great example) in the past 2 years or so.

Investor demand here is unfortunately not in your control.

Competitive landscape

I know so many startups in competitive spaces who are frustrated because they have high revenues but have a lot of trouble raising money.  When they do raise, their valuations are not as high as they would’ve hoped or expected per their revenue.

In crowded verticals, a lot of investors will simply sit on the sidelines and avoid making investments, which limits the number of investors who are writing checks in these spaces.

The takeaway here is NOT that you should stop working on your business in a competitive field  (Remember a little company called Google was like the 7th or 8th search engine and they did just ok. 😉 )  If you are in a competitive space, you should just be cognizant of this.  It will be REALLY important for you to put a LOT of work into your differentiation story  (This is a longer post in itself.)

Compelling components of your business

Revenue can certainly increase your valuation because when you have more revenue, typically more investors will be interested in investing, which increases the investor demand for your round.  That being said, you shouldn’t think, “Oh if I do an extra $1k in revenue next month, my valuation will go up to Y.”  This just doesn’t happen.

Now, what could happen is 1) if you all of a sudden do a LOT LOT LOT more revenue, then you could get a bunch of investors excited simply because you are now in their “range” of traction that they typically invest in;  or 2) if you formed relationships with investors early and have shown good traction progress over time, that additional $1k in progress could compel them to invest, but let’s be clear that it’s not the $1k result itself that is compelling.

Remember, most investors (especially VCs) are looking to invest in billion dollar club companies, so your additional say $1k per month that you do next month, while meaningful and important to your business and something you certainly should be proud of, is very far from proving that you’re in this billion dollar club.

In a similar vein, besides revenue, there are plenty of other components that you control that affect your valuation.  Team is certainly a big one.  What do investors mean by “awesome team”?  Typically the teams that get big valuations for their companies with limited-to-no traction are the ones that have had a previous successful exit before or were execs at well-known fast growth tech companies.  Shy of that, even if you went to or worked at a brand name company like Caltech, Facebook, or Google as a mid-level manager or employee, your team isn’t going to be enough to get investors excited.  (Think about it – there are probably about 1m people who work or went to school at some brand name place worldwide at some point.  You’re not unique).  Therefore, you need other compelling things about your business to increase investor demand, which in turn increases your valuation.

Some verticals will be difficult to get revenue traction in.  Hardware, healthtech, fintech, and govtech are good examples.  Highly regulated industries or capital intensive businesses have different benchmarks that investors are typically looking for.  In regulated businesses, for example, making progress on navigating regulations and approvals will be important to get investors excited.  Even if you can’t start generating revenue today, increase investor demand by making progress on things that you can work on.

Lastly, having a “great” idea is worth a lot – many investors will get excited just by “great” ideas.  Personally, I’m in the camp that most ideas that are great don’t sound great from the get-go and vice-versa.  In my mind, the execution is what makes something a great idea.  That being said, putting yourself in the shoes of an investor, who gets pitched TONS and TONS of ideas everyday, they all start to blend together.  So when a truly unique idea does come along that seemingly makes sense and is creative or clever, it’s really easy to get excited.  When I was on the other side of the fence as an entrepreneur, I had no idea whether an idea was unique relative to all the other startups pitching out there.  Since most pitches are not unique, you should just assume your idea is not unique.  If an investor tells you your idea is clever, then you know you happen to have a unique idea relative to the rest of the pool, and this can potentially help you command a higher valuation.

How you run your fundraising process

The last thing that is in your control is how you run your fundraising process.

If you are only meeting with, say, 5 investors, and you run your fundraising process half-heartedly and not as a full-time activity, then of course, you’re not going to be able to command the valuation you want.  Your effective demand side is only 5 investors in this case!  Even if they want to invest, they can pretty much offer you any terms, and you’ll take it because you have no other options.

I’ll write more on this later, but you need to approach a LOT of investors to essentially create a bidding war for your deal.  This is like an auction.  Let’s say you’re raising $500k, and you have 20 investors who want in at $50k per person; then you have twice as much interest than what your round can accommodate, so your valuation will increase until investors start dropping out because the price is too high.

How you run your fundraising process IS very much in your control and almost more so than your actual business!  I know so many great founders that raise money like a part-time job because they want to focus on building their startups, and then later they are upset that their valuations didn’t end up as high as they thought they should be.  This is why.  If you’re going to fundraise, then you really need to make it your full-time job.  No one is going to approach you and say you’re worth a $10m cap convertible note.  You need to bid your price up with investor competition.

Valuations are set by your round’s supply and investor demand; that’s it.  So the way to think about getting a higher valuation is how you can work some of these levers to increase investor demand.