How to Value an Early-Stage Startup
You may have heard the saying that valuing a startup is more of an art than a science. Without any meaningful operating history, cash flows, or traction, placing a value on a startup for purposes of early-stage fundraising is a difficult task. It’s not surprising that one of the most common questions we’re asked by early-stage startups and investors revolves around this topic. How can a startup come up with a valuation for their Series Seed equity round or a valuation cap for their SAFE or convertible note round? And how can early-stage investors determine what is a reasonable valuation?
This post offers a brief overview of four methods to valuing an early-stage startup for purposes of raising Seed or pre-Seed capital.
We start first with a reference point. In our experience, the average pre-money valuation for an initial Series Seed financing of a traditional startup is right around $5M. This number certainly varies depending on a number of factors, but it’s a helpful reference point as we go through the four methods.
The Points-Based Method
The points-based method takes a scorecard approach to valuation by identifying certain key factors to evaluating a startup, placing a weight on those factors, and then assigning points to those factors. There is no rulebook here, so this method tends to be one of the harder ones to figure out. In general, (1) the factors tend to cover the typical early-stage metrics, such as the founding team, the pain points in the market, the company’s differentiated solution, the size of the addressable market, and the current traction or proof of concept; (2) the weight for each factor is based upon what an investor typically finds most valuable when making an investment decision; and (3) the points assigned to each factor is a subjective determination based upon a comparison to other startups in the industry. Once a total score is established, you can multiply that score by the $5M average Seed valuation (or whatever other reference point you think is appropriate) to come up with a pre-money valuation for your round.
The following example illustrates the points-based method:
|Multiplied by $5M average Seed valuation||$5,250,000
|*Weight ranges from 15%-30% in this example. You can adjust the range as you see fit, but it should equal 100% in the aggregate.
*Points range from .5-1.5 in this example. You can adjust the range as you see fit, but 1.0 should represent the average score that projects a pre-money valuation of $5M (or whatever other reference point you think is appropriate).
Note that these are arbitrary numbers chosen simply for purposes of presenting an example. There are many factors that go into evaluating a startup, and the weight and points attributable to each factor can vary widely. Startups and investors should assess what numbers would be most appropriate in their particular situation.
The Dilution-Based Method
The dilution-based method to valuation takes into account the dollars raised in the financing and the ownership percentage allocated in the financing. In general, startups should raise enough capital to cover their burn rate over a 12-24-month period (18 months is a good target) and should expect to give away somewhere around 15%-25% of the fully-diluted ownership of the company in connection with the raise (this dilution typically goes both to the investors in the round and to an option pool reserve).
The following example illustrates the dilution-based method:
Let’s assume the startup needs to raise $1M to cover it’s 18-month burn and is willing to give up 20% of the company. Divide $1M by 20% to get a $5M post-money valuation. Subtract the $1M in new money to get a $4M pre-money valuation.
The Exit-Based Method
The exit-based method backs into a valuation by looking at the projected exit valuation for the startup and the desired return multiple for the investor. This method tends to work better in a later stage investment when there is more of an operating history to evaluate, but the basic premise is to predict the upside. This requires (among other factors) an analysis of the industry in which the startup operates, including the acquisition value multiples within that industry, as well as the required return for the investor.
The following example illustrates the exit-based method:
Let’s assume the projected acquisition value of the startup in 5-7 years is $45M and the investor is targeting a 10X return. Divide $45M by 10 to get a $4.5M pre-money valuation today.
The Market-Based Method
The market-based method produces a valuation simply by looking at market data. What are the valuations for comparable startups? What is the average valuation for startups generally? You can use resources like AngelList, Crunchbase, CB Insights, Angel Resource Institute, and others for market research. With this method, you essentially go with your gut on valuation based upon what you’re seeing in the market.
While there are variations to these methods as well as many other methods for valuing early-stage startups, these four should give you a good start. And they can also be useful when it comes to setting the valuation cap in a SAFE or convertible note round. In general, the valuation cap should ideally be set at or slightly below the projected pre-money valuation of the company in the qualified equity financing that triggers conversion of the SAFE or convertible note into equity. Therefore, running through these valuation methods should help you make that determination.
Scannavino Lamb LLP is a boutique law firm based in New York City offering legal and strategic advice to forward-thinking entrepreneurs, startup companies, and startup investors. Founded by former Big Law lawyers with a range of experience in corporate law and business transactions, the firm serves its clients by blending world-class service with entrepreneurial perspective. Check us out at www.scannavinolamb.com.
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