Valuations and round sizes of pre-seed and seed start-ups are two of the topics F+L’s Funding team are asked about the most by Founders, and for good reason. There are a huge number of quantitative and qualitative variables that go into both determining the valuation of your start-up and how much money you should be looking to raise when creating your funding strategy.
Here we are going to walk through some of the key things Founders should consider to ensure they are raising a justifiable amount of funds, at a defensible valuation.
Raising a Pre-seed and Seed round will be the most expensive money you raise
When your start-up is raising its pre-seed and seed rounds, you most likely won’t have enough traction to justify a high valuation (irrespective of how valuable you think your company may be in 5 years time). As a result, for every pound you raise in these rounds, you will have to sell a proportionately higher amount of equity compared to later rounds.
For example: to raise £300k at a pre-money valuation of £1.5m, you’ll have to sell 16.7% of your company. However, to raise this same £300k at a pre-money valuation of £5m, you would only need to sell 5.7% of your company.
So I should try and raise at the highest possible valuation?
Unfortunately, it’s not that simple. Investors simply won’t invest in your start-up if they think the valuation is too high and their investment will buy too small a stake in the company.
“Just because you can, doesn’t mean you should”
This is a key adage to consider. Just because you can get a higher-than-expected valuation, it doesn’t necessarily mean you should take it. This will place significant pressure on you to achieve revenue and other traction/growth metrics to justify a lofty valuation, and lead to mis-prioritising the direction and goals of your business for the sake of short-term gain.
Furthermore, you place yourself at risk of a feared down round, where you raise money at a lower valuation in a future round compared to the previous round, as you weren’t able to find investors willing to invest at an increased valuation. This can have both negative reputational and dilutive impacts on your business.
Is there such a thing as raising at too low a valuation?
Whilst raising at too high a valuation can be a red flag for investors, it’s important not to set the bar too low either. It's often the case that Founders need a sizeable amount of funding to allow them to get to revenue, or sometimes gain any kind of traction at all.
Raising too much money at too low a valuation may be easier than raising at a higher valuation - but it will see you and your team over-diluted, meaning you sell so much equity that the Founders and employees hold a smaller and smaller stake in the start-up with each subsequent funding round. This is a bad outcome, as the team may eventually lose the incentive to keep building and growing the company, knowing that they may not have a meaningful windfall from an exit due to their diminished shareholding.
How do I balance valuation and round size?
The optimal way of raising funds is to raise across multiple rounds, each time at a higher valuation. You would generally expect to raise funds approximately every 18-24 months for much earlier staged businesses, with smaller bridging rounds sometimes used if funds are needed between this time, as they often are.
It’s important to have a clear understanding of how to drive a higher valuation in each round (e.g. traction metrics, KPIs and milestones - more on this below), and how much money is needed to deliver these, ensuring you also have sufficient cash flow until your next raise.
Trying to raise too much money too early on can dilute your ownership too quickly, not giving you enough equity to sell to raise funds in future rounds.
For example, raising £750k at a £1.5m pre-money valuation, dilutes you down to 67% ownership.
After two more funding rounds, selling 20% of the company’s equity each time, you would be left with just 43% of the company not owned by investors, which you would need to split between Co-Founders, employees, options pools and any subsequent funding rounds - leaving the founding team with insignificant equity holdings.
A rule of thumb for valuation and round size is that you would expect to sell in the region of 10-20% of the company’s equity in each funding round. Once you’ve determined how much money you need to raise (more on this below), you can get a ballpark understanding of an ‘implied’ valuation by considering whether those funds fall between 10-20% of your post-money valuation.
Consider your round size and valuation from several key perspectives:
- Raise enough funds to allow you to deliver on metrics, KPIs and milestones.
- Raise enough funds that will sustain you from a cash flow perspective until the next raise.
- Set a valuation that ensures the founding team retains enough equity for future funding rounds.
- Set a valuation that gives the investor a large enough stake that they won’t be overdiluted in future funding rounds.
- Not deter existing investors from following on in future rounds.
What drives valuation?
Ultimately, your valuation is the amount that investors are willing to pay. There are a huge number of factors investors consider when evaluating a valuation. Among others, these include:
- Founding Team: Early-stage investors invest in Founders first. The stronger the founding team, the more confidence an investor will have. They’ll consider previous founding experience along with sector, commercial, product and technology expertise as a minimum.
- Wider Team: Consider whether you need to allocate any funds towards hiring people who will complement your team or fill any areas of weakness. Will you need to bring on that extra marketing head to hit your marketing goals? That extra Developer to ensure you can deliver on your product roadmap? A Community Lead to fulfil your engagement KPIs?
- Traction: Simply put, traction is validation. If you have engaged, or better yet, paying customers, you will be in a much better place to justify a higher valuation. Traction is far more than just revenue; depending on sector and stage there are a wide array of other non-revenue metrics to measure traction.
- Sector: Valuations can vary enormously by sector - owing to scalability, cost to replicate, market size and exit opportunities. It’s important to align your valuation with comparable companies within your sector (more on this below).
- Business Model: Simply put, what kind of customers are you targeting, and how will you make money from them? Do your customers have a high LTV/CAC ratio? Are there multiple revenue streams you can deliver on? Are there recurring revenue opportunities?
- IP, Defensibility, Competitive Advantage: You need to show why your business and opportunity is defensible, and why you and your team are best positioned to successfully execute. Consider whether you have any intrinsic IP, and what barriers you can put up to make it difficult for a competitor to challenge you.
There are considerably more things than listed here that can drive a higher valuation that investors will consider when considering a valuation - but these are some headlines.
Consider the drivers you can control, set clear goals for the next 18 months (or until your next planned funding round), and establish what you need to do/invest in to achieve these goals.
How much do I need to raise to deliver on my value-driving metrics, KPIs and milestones?
When an investor asks why you are raising the amount you are raising, a surefire way to impress them is to give a clear breakdown of how the funds will be spent, and what they are going to help you and your business achieve.
Building a robust financial model is the best way to do this. Once you’ve determined the key valuation driving metrics, KPIs and milestones you will use your raised funds for, build them into your financial model.
Once this is all accounted for in your financial model, overlayed against the rest of your forecast, it should be clear from a cash flow perspective how much money you need from your investors, by when, and what the funds will help you achieve.
In order to put yourself into the top tier of Founders, provide a breakdown of the Return On Investment on the funds you’re asking for, broken down to £50k segments. This helps align your round size, goals and valuation in a clear, pragmatic, investable way.
How to get to an appropriate valuation for your start-up
So far, we have considered how much money you need to raise, and have provided context to what drives valuation and how investors consider valuation drivers. It’s now time to consider which valuation methodologies are most appropriate for you and your start-up.
There are multiple methods you can use - the appropriateness depends on the maturity of your business or the types of investors you are seeking.
- Established businesses:
- A Discounted Cashflow model (DCF): Very useful way to value a business, but is better suited for more established companies doing larger raises (typically with Venture Capital and Private Equity investors).
- EBITDA or revenue multiple: This method multiplies by EBITDA or revenue by the sector ‘standard’ multiple to arrive at a valuation. However, early-stage companies tend to have negative EBITDA and low revenues (if any) so is less appropriate for pre-seed and seed-stage companies.
- Early-stage businesses: There are some more qualitative methods available for earlier stage companies without established revenues.
- Berkus/Checklist method: Assesses a company based on five criteria, assigning value for each. Those are Sound Idea (the company has an exciting business idea), Quality Management Team (the company has assembled a strong team, reducing execution risk), Prototype (the company has a solid product/prototype, reducing technology risk), Strategic Relationships (the company has powerful strategic partners and/or a burgeoning customer base, reducing market risk and competitive risk), and Product Rollout or Sales (the company has signs of revenue growth and a pathway to profitability, reducing financial or production risk).
- Scorecard method: Considers other start-ups in your sector who have received funding and assigns value based on a comparative score.
For early-stage start-ups, there are valuation platforms such as GrowthVal and Equidam that provide a valuation based on a weighting of several different methods, dependent on sector and maturity. These can be a useful exercise to see if your valuation is in the right ballpark.
The investor perspective
Investors are ultimately going to use a combination of methods to determine whether your valuation is appropriate.
They have the benefit of having a lot of deal flow - they see a lot of investor decks and pitches, so will have a good understanding of how a valuation benchmarks against other companies in the same sector or at the same stage of development.
They will then be able to make adjustments to that ‘market rate’ valuation benchmark to factor in nuances about your company - the strength of the founding team, defensibility etc.
So I should just look at what other companies are valued at?
Not quite. Once you have:
- Mapped out what metrics, KPIs and milestones you’re going to target between now and your next round;
- Built a financial model showing how much money you need to deliver these targets;
- Considered a valuation that leaves you with enough equity for subsequent funding rounds;
You can then do your market research to ensure the amount of money you are asking for and the valuation align with other deals investors will be seeing.
It can be difficult to find information on pre-seed and seed funding rounds. Start thinking about your competitors, and look online for articles and press releases to see if there is any information on their funding rounds. Sites like Crunchbase are a great resource for funding round intelligence.
Better yet, get into the mind of an investor. Speak to investors within your network and ask for feedback on your valuation. You could even go as far as joining investor groups, networks, platforms and Q&As as a way to get a better understanding of what valuation other comparable start-ups are raising at.
As you can see, there are a huge number of variables to consider when determining your start-up's valuation and round size, two important steps when you prepare to raise investment. If an investor is truly interested in investing in you and your business, they will no doubt engage in conversation or negotiation with you to either justify or challenge your valuation. Have your funding strategy ready and ensure your raise target is based on your roadmap and valuation.
Should you need help determining exactly what kind of metrics, KPIs and milestones you ought to be targeting, how much this might cost you, how to build a financial model or if you need guidance on what an appropriate valuation is, please do reach out to the team at firstname.lastname@example.org.