Valuation Equation
A great developer I know started building an app and now has more traction than he expected. He’s trying to figure out how to sustain the development by expanding his team. Cash strapped to pay salaries, he’s considering raising money to continue expansion of the app.
We’ve been going back and forth on how to navigate terms for an early stage fundraise so I thought I’d share some of those ideas here.
Equation to calculate valuation:
1) How much of the business are you willing to give up? Typically 10-20% in a seed round, but can be less if you need less money.
2) How much money do you need to get you through the next 12-18 months? or to prove the next big milestone so you can fundraise for your next round. You may be able to get profitable off of one fundraise, but if not, think ahead for how much money you need to buy you the time you need to prove progress.
3) Valuation is this equation : Valuation = money you need /% you’re willing to give up.
If it’s $75k / 12% = $625,000 valuation, $700,000 post money
If it’s 100k / 10% = $1M valuation, 1.1M post money.
Determining if it’s a fair valuation:
1) Valuations are usually based on the future value of the company after you take this money. So the company may not be worth $700,000 today but with $75k of capital, you’ll be able to get it to that value.
2) How do you determine the value if you don’t have revenue to base the ‘worth’ off of? This is the tricky part. Danny Crichton provides a deep analysis in his “Complete Quantitative Guide To Judging Your Startup” (thanks to Stash for sharing) but even with lots of data, it’s still up to the investor. Serial investors or institutions should have a rough benchmark of traction, potential and growth that they can make an offer on valuation.
Don’t forget the big picture
From my VC & entrepreneurship experience, early stage valuations are more of an art than a science. A few things to remember when doing the fundraising dance:
- You can always raise less money. For example, if you only need $50k to get to your next milestone, take the $50k in January and use that money to build the business. By August you may have great traction, revenue or engagement metrics that place a higher valuation on the company. You may decide to raise $250 - $1M at that point.
If you raised more money earlier, you may have sold equity at a higher cost than you needed to. In this example, if the valuation on your company was $500k in January, if you raised $50k you’d be selling 10% of equity. If you tried to raise $250k in January, you’d be selling 50% of your equity, not a good idea.
- You might not need venture capital now. There are ways to bootstrap, find alternative sources of capital and further prove your idea today. Mark Suster does a great job covering this point here. Many alternatives cost zero equity.
- Think about your future rounds. Fundraising isn’t just about the capital you raise today, it’s potentially a piece of a longer path. The valuation, capital and time that you negotiate for now will impact your next fundraise. If your valuation is too high now, it’ll be more difficult to negotiate a higher valuation down the road. If your burn is too high for the amount you raise, you may not have enough time to grow the business. The early investors you work with may not be willing or able to invest in future rounds. This will impact your strategy for your next raise.
- Keep your cap table clean. If you have a messy foundation, it gets harder with each round to clean it up. Make sure equity is properly allocated, accounted for and setup with vesting schedules to keep team members and advisors properly engaged. Equity may seem cheap early on, but it feels much more expensive once you start selling it to investors. I’ve made this mistake in the past and it’s an expensive one to learn.
- Valuation is set by the person writing the check. You may want a certain price, but it’s only possible if the market is willing to pay it. This is a negotiation, so figure out what the market wants. There are tradeoffs between “easy money” and “smart money” so don’t forget to evaluate what you’re getting in return from the investors.
For answers to many frequently asked questions, Mark Suster has shared a Raising Venture Capital guide here.
Something to share?
I want to hear from you! If you or your team have something to add or challenge, please share in the comments below or on Twitter.
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