How should you value your startup?

Welcome to Nelson’s Newsletter, where founders learn the skills and knowledge they need to nail their next fundraise.

Today, we’re talking about valuations.

It can be tough to value your startup. How do you value a company with no product, no customers, and no tangible assets? How do you value an idea?

Here’s what you need to know to value your startup in a way that attracts investors and preserves your equity.

Share value

A startup’s valuation is determined by how much investors are willing to pay for its shares.

A startup that sells 10% of the company for $100k is valued at $1m. If they sold those shares for $200k instead, it would be valued at $2m.

For founders new to VC, it might seem bonkers to value a new company so highly. Here’s Paul Graham on his experience:

When early-stage investors buy shares in a startup, they’re buying its potential to create value in the future. They’re making a bet that its valuation will increase in line with the value it creates and they’ll be able to sell their shares for more than they bought them.

So how much is a startup worth? Whatever investors are prepared to pay for it.

Do valuations matter?

Yes and no. They certainly matter, or I wouldn’t be writing about them, but not to the extent most founders think.

Success for VC-backed startups is more binary than it is for bootstrapped companies, because founders are incentivised by the model to chase massive returns. Most will fail but big winners may return 10-25x their initial investment or more to their investors.

When a startup fails, the pie is non-existent, so it doesn’t matter who owns what.

When a startup is a big winner, the pie is normally so big that even when founders have a slightly smaller slice, they still do very well for themselves.

Where valuations can play a larger role for founders is when the startup doesn’t fail but doesn’t become a runaway success either. In these situations, founders may find they’ve given up so much equity that even if they do exit, they get a smaller amount than they expected or even leave with nothing, due to investors’ preferred shares meaning they get paid before founders.

That’s a scary thought, so let’s try to avoid the most common pitfalls by understanding typical preseed and seed round valuations.

Typical valuations

First things first, these are intended to be rough figures. There are plenty of exceptions, for instance Stability AI, who raised a $98.8 million seed round last year. (I wonder if it bugged them to not get a round $100m? When one of our supposedly ‘confirmed’ angels ghosted us in our preseed, we rooted around for an extra $20k to take us to $1m. It just felt so much nicer than raising $980k. On a related note, that’s how we learned nothing is ‘confirmed’ until the money is actually in your bank account. Angels suffer buyer’s remorse more commonly than VCs, but in rare cases they’ll pull term sheets after offering them, as they’re not legally binding. This is more common with less well-known firms, as top tier VCs have more of a reputation to protect.)

Let’s take a look at the usual valuation ranges for preseed and seed stages:

Preseed rounds

Startups that raise preseed rounds tend to offer 5-10% equity to friends and family or angels, in return for tens of thousands to the low hundreds of thousands of dollars. Larger preseeds can include smaller VC firms, and up to $1m investment for 15% equity. Preseeds are normally valued at less than $5 million.

(At my last startup, we raised a preseed of $1 million for 15% equity at a valuation of $6.67 million post-money. Post-money means how much the startup is worth after the new investment has been taken into account. Pre-money is before the investment, in this case $5.67m.)

Seed rounds

Startups may offer up to 25% equity to larger angels, VC firms, and follow-on investors from their preseed who secured Pro Rata or Pre-Emptive Rights (the ability, but not the obligation, to take part in future rounds so they can keep the same percentage of shares). They normally raise $1-3 million but many raise far more, as we saw above. The median US seed round for Q1 2023 was $2.3 million. Most seed stage startups are valued at between $5 and $15 million.

The best way to find up-to-date valuations for your industry is to ask founder friends who raised VC about their funding rounds. You can also use Crunchbase or StrictlyVC to see how much startups raised and then estimate their valuations using the equity ranges we covered above (5-15% equity for preseed, up to 25% for seed). Friendly VCs will also give advice on what they’re seeing, but unless you know how to navigate the VC process extremely well, I’d only ask VCs you’re not planning to ask to invest. Even then, be aware that they talk to each other.

If in doubt, use the above figures as a starting point and adjust accordingly based on your:

• Startup - the pedigree of your founding team, what you’ve accomplished, growth rate etc.

• Industry - some industries see higher average valuations (e.g. Fintech seems to get higher valuations than Proptech), and industries can go from hot to not in weeks (web3 is a recent example).

• Market conditions - Zero Interest Rate Policy meant more capital and higher valuations. Corrections or crashes typically mean less capital, more competition between startups and lower valuations.

Using those rules of thumb, you’re more likely to achieve a higher valuation if you have a genuinely world-class team of serial founders in a hot industry at the top of a market cycle than a first-time founder in a lower-demand industry during a recession.

How much should you raise?

I’ll go into more depth on this another time, but a decent rule of thumb is to evaluate what you think it’ll take to achieve the next funding round and reverse engineer how much money you think it’ll take to get there.

That means a startup seeking preseed funding needs to secure enough cash to meet all the milestones they need to raise a seed, and a startup seeking seed funding needs to have their mind on a Series A.

Preseed startups should raise enough to build a product that shows good traction and encouraging signs of PMF. To get there they may need to hire a small number of employees, rent office space and buy equipment. Typically startups at this stage budget for 12-18 months.

Startups seeking seed funding should raise enough to stand a good chance of raising a Series A in 12-24 months’ time. Typically, this means PMF, high growth and solid revenue. Most investors won’t expect profitability, growth is normally the most important factor.

Preparing your costs

Create a spreadsheet with your planned costs, including salaries for team members, office hire, equipment and software, as well as setting money aside for customer acquisition, travel and other miscellaneous expenses. Your country may also require you to pay additional taxes and employee benefits. Add a column for each month and rows for each cost, and then tally the total at the bottom as you go.

Once you’ve entered all your costs, add another 20% to cover things you’ve forgotten or underestimated. That’s not very scientific, but things always cost more and take longer than we think. Always.

I’m going to assume you have a fixed number in mind to raise. I’ll cover why it’s actually better to have a range of investment options in a future newsletter, but for now that minimum amount will give us a good foundation for the next step.

Now we know how much we want to raise, we need to decide how much of our company we’re willing to give up.

The less equity we offer, the less of our company we lose control of, and the higher our valuation, so does that mean we should aim for a large valuation?

Bigger isn’t always better

High valuations are a double-edged sword. On one hand, a high valuation means you give up less equity so keep more of the company, but on the other, a high valuation can hurt you later, even if it feels like a win at the time.

Investors will judge your progress against your valuation, and sky-high valuations mean sky-high expectations. Fail to meet those and you may fail to raise your next round at any valuation.

Even if you’re confident in your progress, sometimes the market has other ideas. When bubbles burst or recession hits, valuations shrink. Those who can’t afford a more modest valuation because their last one was so high must face the dreaded down round, which is far harder to pull off.

At my last startup, several well-meaning investors advised us to raise at a $10-12m valuation, rather than our planned $6.67m. When the market crashed, those who had chased high valuations were in an especially tough spot. Most closed within six months or are de facto dead but just don’t know it yet. As it happens, we met the same fate despite our decision to pursue a more conservative valuation. Such is startup life, but at least we gave ourselves a fighting chance.

Why do some founders chase high valuations? Firstly, they give up less equity. Secondly, having investors who are willing to pay more to own less of the company sends a strong signal to future investors, competitors, partners and employees. Thirdly, founders are a competitive bunch, so fundraising can become a minigame that quickly devolves into a pissing contest of who can raise more at a higher valuation. The first and second reasons are valid, but can be taken too far. The third should be avoided at all costs.

As Oren Michels, former CEO of Mashery tells it:

So, what does a good valuation look like?

You’re trying to find the sweet spot where the opportunity is enticing to investors, without diluting yourself too much, or overshooting such that you’re able to raise this round, but may struggle to raise the next one. And it’s less of a sweet spot, and more like a sweet range.

Calculating a valuation

Once you’ve done your research and have an idea of your costs and how much equity you’re prepared to offer, plug the different options into a free valuation calculator to see how each one shakes out.

The next step is to take these figures and ask your founder friends if they seem reasonable. (You can also shoot me a quick email if you’re in a jam.)

It’s easy to get hung up on valuations, but try not to lose sight of the real goal: getting the money you need to grow your company, at reasonable terms, as fast as you possibly can, so you can get back to what really matters - creating a product that people want.

Fundraising is just a means to an end.

I hope that’s been helpful! If you have any questions, want me to cover something specific in a future newsletter, or just want to chat about startups, hit reply and say hello.

Speak soon,

Nelson