How Pre-Seed and Seed Valuations Actually Work

After being on two panels on fundraising last month—one at the London AWS Startup Loft Accelerator the other the Modern Data Summit hosted by Modern Data Stack and Carmen Alfonso Rico —my brain has been stuck on a topic that founders at both events asked about: early stage valuations.

Your startup, before you have customers and revenue, is worth ZERO.

So, the valuation of your Pre-Seed/Seed round has nothing to do with the value of the company. Let's go through the actual factors that move a pre-rev / pre-users valuation, one by one.

The bigger the round size, which should be how much money it will take you to get to the right set of metrics to prove enough of your thesis to raise the next round—features shipped, design partners secured, user growth, revenue, whatever—the higher the valuation needs to be.

Why “needs”? Because the lead VC, the one who gives you a termsheet, “prices” the round, that person typically has an ownership target. Let’s say you’re raising $3M. If I want 10% of the company && I agree to $3M, the “post money” will be $30M [30 * 0.1 = 3].

But in reality, the lead VC doesn't "do" the whole round. They take the largest individual share. For a $3M round, I’m likely only doing 2M, while angels or other parties are doing the remaining 1M. Now, there’s a ceiling of 20M on the valuation for me to hit my ownership target [20 * 0.1 = 2].

Which brings us to: how much dilution you are willing to take—how much of your company are you willing to sell, thereby reducing your own ownership. Keep in mind that you will do so at every round.

At “3 on 30 post”, you are selling 10%. At 3 on 20 post, you are selling 15%.

Those are not the same. As you sell __% at each round, you’re moving through a countdown until when the math will stop making sense for you (ignoring a lot of other factors). It’s also a countdown to when the math will stop making sense for me, the VC. We are both going to get diluted, at every round. Our separate ownership stakes will go down.

Why does the math stop working? Because the "exit value" of your company, what it is worth at acquisition or IPO, has to be proportionally higher for you or I to make the same amount of money at every stage.

Assuming everything goes well, the valuation at each round will go up, because you’ve gotten closer and closer to achieving an exit value greater than the previous valuation. Investors will start thinking about your potential “terminal” value, where the curve of revenue growth levels off, through extrapolation. Each new investor will invest more money, with their own ownership target or return needs, requiring a proportionally higher exit to achieve their goals.

But there’s a definite delta between exit value and valuation. This is the big unknown. The risk investors take is that you not only close that gap, but flip it, such that exit value > valuation by multiples, so that when they sell their stakes in the company, they get back multiples of what they paid. Early stage investors like us here at Crane Venture Partners take the biggest risk in that sense, even though we put the least absolute money to work.

The remaining factors which move your valuation are things that “decrease” [heavy scare quotes] that risk.

• Who you are, history of success, experience building products like this, experience building teams, existing network of support or future customers or future staff, willingness and ability to do things like figure out sales, etc.
• How big your market is—how many potential paying customers at what amount per customer per year at max usage with a hefty discount cause you’re not getting 100% of any market… today, next year, in 5 yrs, in 10 yrs.?
• How much existing competition there is, how much emerging completion there is, how much competition there will be in the future.?
• How unique, differentiated, and defensible, your product or go to market is and will be.
• How fast you will be able to achieve growth, today, next year, in 5 yrs… and what that curve could be, like does it max out at linear or could it be exponential long enough for an exit.

Not a single one of those things reflect any actual value in your company right now, especially if you are pre product, which is ZERO.

To sum up—Pre-Seed and Seed valuations are derivative of [investment x ownership x “de-risking factors”]. At later stages, there's more info, and it's more possible to be objective and have industry benchmarks or public market comparables to judge your success against.

Good luck out there! ????????