Valuing a company in a seed round is a critical skill for any venture capitalist because the investment is so early on in the company’s life. This means very high risk, but even seasoned VC’s with absurdly high-risk tolerance still want to do their due diligence to mitigate that risk.
The formula for valuing a business during investment negotiations is:
Value ($) = Investment ($) / Equity Stake (%)
During a seed round, investors look for more intangible aspects like proof of traction and the company’s ability to “bootstrap” to validate the valuation, rather than financial data.
To the layman, valuing a company can seem like a bunch of smoke and mirrors. This guide is here to clear the smoke and move the mirrors. We’ll define the lingo, put it into context, and leave you ready to invest in your buddy’s new startup… or maybe, more importantly, help you walk away from a bad deal.
First, The Definition Of A Seed Round
Funding a startup happens in rounds. There are seed rounds and series rounds. This article addresses the seed round, but we’ll briefly touch on series rounds as well to provide some contrast.
Venture capitalism and Angel Investing are all about getting in on the ground floor, right? Well, a seed round is an investment below the ground floor. The most common metaphor is of a tree. A business is a tree, and a good, healthy business grows like a good, healthy tree does. The tree did not come out of thin-air though; a seed was planted.
So a seed round is usually the very first round of fundraising for a business, planting the “seed” of what will eventually grow into a thriving business.
That seed comes in the form of money, and it’s given in exchange for an equity stake in the company. Now, to quickly address series rounds, we’ll add to our metaphor.
Now that the seed is planted and has sprouted, what does our tree need to grow? Water and sunlight.
This is where series investment rounds come in. The money raised in these rounds is the water and sunlight the baby tree needs to grow and flourish. And consider the business founders the caretakers of this tree.
They are the ones actually watering it once the investors have filled up the can, and they are the ones pruning other trees that would block the sun’s rays after investors have cleared the clouds.
That’s a nice metaphor, but what does that caretaking actually look like during a seed round?
What Does The Business Do During A Seed Round?
According to RocketSpace, this is where founders will use seed money to solidify their business foundation. Good uses of seed round capital include:
- Filling knowledge gaps by hiring more key players. Smart founders will identify their weaknesses and hire to address them.
- Performing deeper market testing to further validate the MVP and the business model
- Developing and strengthening relationships with instrumental business partners
These are all activities that, if done properly and diligently, will yield a robust foundation for the business to take hold.
What Do Investors Do During A Seed Round?
In a seed round, investors want proof that their money will be used for the above activities. Ideally, for business founders, investors in a seed round will bring more to the table than just money, a term known as “smart money.” They may also bring with them:
- Marketing channels
- Knowledge of competition
- Connection to top industry talent
All of this will come at an equity cost, and early on in a seed round founders may be hesitant to give up that much, knowing further dilution is ahead during series rounds. If that’s the case, they may opt for a more passive seed investor.
These kinds of investors are typically friends and family of the founders. If they have an impressive net worth and a soft spot in their hearts for the founders, they can be convinced to help get a business off the ground.
This money will be more passive, though. Unless these friends or family members are professional angel investors, they’ll probably be pretty hands-off along the way. This means founders can typically hold on to more equity in their company, leaving the flexibility to really fine-tune their product and pivot as necessary.
We’ve started to touch on equity a little here, so it’s time to get into the nuts and bolts of valuing a company during a seed round.
So, How Is A Seed Company Valued?
Valuing a company is what gives founders and investors food for negotiation. It’s a way to ground future financial projections in the present moment, and then translate that grounded projection into a return on investment for a venture capitalist.
If the projections are bogus, an investor won’t buy the glorious returns they are being pitched. If the projections are solid and based in proven financial business performance, the founders have more negotiating power.
During these negotiations, it’s best to know this equation like the back of your hand.
Post-Money Value (in dollars) = Investment Amount (in dollars) / Equity Stake (percentage)
Good negotiators are able to do this math on their feet in the heat of the negotiation. It’s a must if either the entrepreneur or the investor wants to know if they’re getting a raw deal. Fundamentally, investors want higher equity stakes, and business owners want a lower cost of capital (higher valuation).
We’ll dig into the variables at play here, but first, a quick example.
Some Tech Startup, inc. is negotiating with an angel investor. They need money to fill their knowledge gaps and refine their minimum viable product. They ask for $50,000 in exchange for 10% of their company.
$50,000 is the investment amount, and 10% is the equity stake. Plugging those numbers into the formula above, this puts the value of the company at $500,000.
In this scenario, the entrepreneurs maintain 90% ownership of their company. However, the investor thinks this is a risky investment and wants to mitigate it. The counter-offer is $50,000 for 25%. This drops the value of the company to $200,000.
That’s a big swing in value! But if the business does realize that $500,000 value, then the investor gets a bigger piece of that pie. And conversely, the entrepreneurs have given up that piece of the pie.
A strong prediction of what this actual value is will help business founders dig their heels in when investors come in with counter offers like that. Likewise, a strong understanding of the potential value will tell an investor whether or not they are getting a good deal.
So how is a company valued by investors? First, we’ll start by defining the terms of the equation above in a bit more detail. Then, we’ll discuss some of the “non-financial” signs of value to look for in young companies without much financial data.
The first number to consider is the current value of the company. This is an important number as it gives negotiations a foothold rooted in current reality.
Post-money value is what the company is worth including any investment. A pre-money valuation does not include the investor’s money. This is an important term to understand as it will impact the amount of equity a given investment gets.
With enough financial data, there are three common ways to calculate this number. However, all of these methods only really work when a company has been long established or at least has a handful of years of revenue.
In a seed round, though, a business could very well be in its pre-revenue stages. So trying to use methods like the discounted cash flow method will only leave you scratching your head.
This does not mean all companies in a seed round of funding will have no financial data. In fact, if they don’t have any, then that is a sign of just how early the investment is coming in. At this point in the company’s life, the exit value is more of a fluid negotiating chip, rather than a number rooted in hard data.
If the founders have a solid business plan and financial model, then this value can be estimated. Honestly, at this stage in the game, exit values are drawn very much from investors’ experience and gut feel.
Super straightforward. This is the number of dollars an investor gives the business to go spend it on the things they need to get off the ground. This is where traction is important. If the business hasn’t made much money yet, an investor will want to know in detail what they have done so far. This puts what they plan to do next, with the investment, into context, and gives the investor confidence that it will happen.
More on traction later. First, what’s in it for the investor?
Depending on the stage of funding and the age of the business, there are different equity types, each with their own nuances.
During a seed round, investors will be buying straight equity in the company. This is known as a “SAFE” investment. Which stands for Simple Agreement for Future Equity.
So, as mentioned before, investors are trading their money for a piece of the whole company. The percentage value is the amount of the company they are buying.
Investors are after the highest possible equity stake. And at this stage in the game, business owners will expect more than just money in exchange for that equity. They’ll want “smart money” as we’ve mentioned earlier.
Equity stake may be the only term in the formula above, but it is not the only thing investors look at. Time is money, right? So the amount of time it takes to reach that valuation is a big deal for investors.
Rate Of Return
Smart investors will heed Stephen Covey’s advice and “begin with the end in mind.” Not only are they thinking of the current post-money value of the company today, but they’re also looking ahead to the exit value.
What is exit value? It’s the price you think the company would sell for some time after the initial investment.
Along with their equity stake, they want to know how long it will take to earn their initial investment back and start making money. For this, they will look at a company’s finances. Numbers like EBIT and Free Cash Flow can help determine how much a company will grow and in how much time.
Again though, this is a seed round. Angel investors are typically going to look to the long term, less quantitative aspects of the company. Here’s what the Corporate Finance Institute says:
“Angels and seed investors focus more on qualitative factors such as who the founders are, high-level reasons why the business should be a big success, and ideas about product-market fit.”
These qualitative factors are typically referred to as traction. Before a business starts making real revenue and growing organically, it has to make traction in the market somehow. There are specific signs that seed investors will look for in the early stages of a startup.
A Word On Traction
Without much of a financial track record, it’s hard to value a company based solely on financials. Typically, financial traction looks like growing sales and increasing profit margins. But how can you tell if a company has made any traction when they’re so new that they literally can’t present those numbers to you.
We’ll discuss a few key, non-financial signs of early traction to look for. Some early signs of traction that don’t consider real sales include:
- Customer acquisition cost
- Contracts with big-time customers
- Public statements from industry experts
Customer Acquisition Cost
Business founders looking for investors will love to talk about growth. They’ll entice them with hockey stick charts, and growing sales numbers (if they have them). All of this is great, but it does not complete the picture.
This growth comes at a cost to them, and one of the biggest costs is actually acquiring customers. This is known as the Customer Acquisition Cost, or CAC. So if a company is pitching you on their growth, a good question to ask is what their CAC looks like.
If you get blank stares, red flag, but not a conversation killer. Ask for the following metrics:
- Money spent on marketing
- Number of real customers to date.
The formula for CAC is simple:
CAC = Dollars Spent on Marketing ÷ Number of Real Customers
So you can do your own math to determine the company’s CAC if they don’t have it readily available. What you’re looking for is a decline in CAC with an increase in revenue over time.
Why? Intercom puts it simply:
“…if your customer acquisition cost is greater than your revenue for a long enough period of time, you’ll go out of business. Kind of a big deal, huh?”
Bringing it back to a seed round. The business may not have been around long enough to provide a solid track record of declining CAC. What you want to look for here is proof of effort to do so.
- What is the current CAC?
- What efforts have been made to reduce CAC so far?
- What plans or tests are being put in place to do so?
- Are they working? Why?
Founders’ ability to field these questions is a good sign that they are thinking of the long-term, sustainable growth and aren’t just trying to make it to that ever-elusive IPO date.
Big Time Contracts
If a company doesn’t have many sales during a seed round, the next best thing may very well be large contracts with big customers. If big retail or industry players have signed up to buy the product, this is a sign of sales to come. As entrepreneur.com puts it,
“Inking contracts with big names like IBM, AT&T, or Walmart, is a strong indication of traction.”
These companies know their customers inside and out, so they will only pick up products that they know will sell. This is a good sign for you as an investor as it shows promise in both sales to come and the overall competence of the founding team.
Another sign of traction is market penetration, but this is difficult to quantify so early on in a seed round. Big time contracts serve as a sign of the potential market share to come, and may even be considered a precursor to the market penetration threshold.
Industry Expert Public Endorsement
Speaking of business founders competence, here’s another sign of that. A public endorsement from an industry expert signifies a couple of things:
- Credibility of the product/business
- Founding members ability to “belong” in the industry
It means the business founders have been able to sell an expert on their product enough to convince them to stick their neck out publicly and endorse the product. This is a certain sign of traction in the absence of a substantial financial record!
The metrics above prove that the founders of the company have been able to successfully “bootstrap” their way to the market. It’s proof that, despite the fact that they need your money, they’re capable of moving on and succeeding with or without your investment. This is desirable.
During a seed round, a company will have some sales and financials; if they don’t, that’s a red flag. If they do, but there’s not enough for the financials to talk for themselves yet, then understanding the signs of traction above will help an investor determine the parameters needed to strengthen their valuation.
Putting It All Together
Smart entrepreneurs will use proof of traction to leverage what little financial data their business has in a seed round. These qualitative measures carry much more weight this early on, and experienced angel investors know what to look for because they are typically entrepreneurs themselves who have made it and are looking for what’s next.
A high valuation may very well be justified if it’s grounded in rock-solid traction. Conversely, little traction and a high valuation will make investors wary.
Other Ways To Add Value To A Startup
So we’ve established that traction is very important during a seed round. One surefire way to gain traction is to focus on adding value.
This is how you as an entrepreneur, are going to seal those big-time contracts, lower your CAC, or secure an industry expert’s endorsement. Once you do that, the investors will be chomping at the bit for a piece of your enterprise.
Here are a few ways a founding team can add value to their business or product:
- Nimble service
- Higher quality product
- Keeping a pulse on lifestyle trends
- Skin in the game
Fast, Reliable Service
Want a prime example of this in action? Look to Amazon. Amazon prime knows it’s customers want their products fast. Consider this illustration of speed as value.
You have two competing businesses with an identical product; I mean, the only difference between these two products is the logo. They’re priced the same; they’re the same quality, they’re the same darn thing. However! When you buy from Business A, you get the product today, but if you buy from Business B, you need to wait 5 days for your product.
Business A is more valuable in this example because their operation adds value to your life by taking up as little time as possible to complete the transaction.
Sometimes, though, a product is worth the wait. This is usually because the value comes in the form of quality instead of time. If Product A has a quality twice as high as Product B, but a price only 10% higher, then Product A is the more valuable option. Think the term “more bang for your buck.”
Entrepreneurs adding value to their business or product will find ways to maintain quality while lowering the price to compete in the market.
Understanding Consumer Lifestyle Trends
Another great example is Amazon. They sniffed out a general lifestyle change towards more online shopping than in-person shopping.
Entrepreneurs who understand the changing lifestyle of their consumers can adapt accordingly. New consumer habits mean new areas to add value, and it’s constantly evolving. Successful businesses understand the value of adapting.
Putting Skin In the Game
This is more so a sign of value for investors, but consumers inadvertently feel the effects when a founding team is all-in on their product.
Business owners who have bet the farm and have everything to lose are usually the ones who find a way to succeed. They are doing what they do because they strive to add value to their customers. For them, the money is secondary.
So clearly, value is what’s important. The current and future values of a business are the bedrock of any negotiations between investors and business owners. Still, they are not the only ones concerned with the value of their endeavor.
One Last Word On The Importance of Value
Any good entrepreneur has one goal in mind. Provide value to the world.
Any good investor looks for one thing when shelling out money. Are they investing in something that provides value to the world?
Money does not create value; value is what creates money. Successful entrepreneurs and investors know this. And smart stakeholders know this as well.
Another key stakeholder that hasn’t been mentioned yet are employees of a startup. Top talent knows it’s value, they can be hired anywhere and paid a big, beautiful salary. Why would someone pass up a six-figure salary to get paid peanuts at a startup?
A promising valuation.
Early startup employees are also technically investors in a startup. Instead of investing money, they invest their time and effort. This too is exchanged for equity in the company.
So when acquiring talent, business owners best know their venture’s value if they want to make competitive offers to top industry talent. This was also briefly mentioned when we discussed traction.
Angel and seed investors like to see that top talent decided to pass up a cushy salary elsewhere and put all their skin in the startup game. This is a solid testament in the team’s belief in their product and capability to execute.
While there are many technical ways to calculate and predict a business’s value based on financial data, angel investors in a seed round must look for more qualitative signs of value.
Successful startups will understand what they need to do in order to make traction without money from investors. It’s almost paradoxical, but investors want to invest in businesses that can succeed with or without their money.
The value of a company in dollar signs is important, but the traction they’ve made is what’s truly priceless to investors.