Raising venture capital as an early-stage founder can be daunting. One challenge of fundraising is settling on a valuation with investors that attracts capital but doesn’t give away too much of your company early on.
The traditional way that investors approach valuation — with long spreadsheets and robust financial analysis — doesn’t quite work when you’re early in the process of building a company. At this stage, valuation is as much an art as it is a science.
In this article, we’ll explain how early-stage investors think about valuation so you can be better prepared when embarking on your own fundraising journey for the first time.
Key due diligence criteria for early-stage investors
Before an investor can determine an appropriate valuation for your company, they first want to answer the question, “Is this an opportunity I’m interested in?”
At the early stages of company building, there is limited performance history for investors to analyze. Instead, investors will pay close attention to your team’s experience and the potential for you to build a big business.
Here are some top considerations for early-stage investors when reviewing an investment opportunity.
Team
A startup’s team composition is the leading indicator for success at the earliest stages of building a company. When historical performance is limited, investors determine the likelihood of a positive liquidity event based on the experience and demonstrated ability of the early team members.
- Have the founders been successful entrepreneurs before?
- Has anyone on the early team worked together at previous companies?
- Does the team have domain expertise and why are they the right people to solve the problem now?
Market
Investors like partnering with companies that are building products to serve large markets.
As a founder, it’s important for you to succinctly communicate what the largest possible market for your product is — the Total Addressable Market (TAM). Your market analysis further breaks down to which subsector of the market has demand for your product — the Service Available Market (SAM) — and which portion of the SAM is realistically obtainable in the near-term future — the Service Obtainable Market (SOM).
Investors utilize either a top-down or bottom-up approach to market sizing. A top-down approach begins by estimating the size of the overall market before calculating your company’s potential market share. On the other hand, a bottom-up approach begins with your company’s unit economics and is expanded to estimate your company’s potential value capture from serving your target market.
Traction
At the earliest stages, traction is all about showing signs of customer interest. It’s important to note that company traction at this stage will vary and there’s no one-size-fits-all example.
In the seed stage, early traction gives an investor validation that you have people interested in what you’re building. This could look like waitlist signups, letters of intent (LOIs), or your first customers.
As your company grows and you prepare to raise a Series A round, investors will begin looking at your revenue and customer growth rates, interest from enterprise customers (if applicable), and other signs of growing traction across product development and sales.
Customer satisfaction
How much do your early customers love your product?
Anecdotal feedback from customers is part of the “art” of early-stage valuation. It is one of the best ways investors can understand if your product is a “painkiller” solution.
Asked about what he considers the most important part of early-stage due diligence, Jason Calacanis, founder of LAUNCH, noted that it’s all about talking to customers. “Doing so helps us understand the startup's current level of product-market fit,” he says. “You can ask a customer two simple questions during this process: ‘How would you solve this problem if this startup didn't exist?’ and ‘How did you solve this before you partnered with this startup?’”
Customers are the real value-creators of a company and a core stakeholder that investors will want to get to know when analyzing an investment opportunity.
Financials
Financial performance is limited at the earliest stages but starts to take shape during the Series A fundraising round.
Financial projections for early-stage investments are not very informative as a data point for investors, but creating basic financial projections as a founder still shows investors how you think about the future growth of your company and its basic unit economics.
Therefore, it’s recommended that you create forward-looking financial statements that outline basic line items, such as revenue and expenses, including customer acquisition costs and customer lifetime value (LTV), along with reasoning and validation to support your projections.
Which investment type to expect from early-stage investors
Early-stage investors today typically invest through a Simple Agreement for Future Equity (SAFE) or priced equity.
In seed rounds, investors and founders often use SAFEs to avoid much of the cost and time required to draft equity financing documents. Additionally, SAFEs allow both parties to delay the task of pricing shares of a company given the lack of financial performance and data available.
The Series A round is usually a founder’s first priced equity round — meaning that an official price per share will be agreed upon and the company will have a true valuation.
However, regardless of the investment type that is used for fundraising, investors are valuing the company directly via a priced equity round, or indirectly, via a SAFE term referred to as a “valuation cap,” which is the equity valuation that a SAFE will convert into at the next qualified financing.
How early-stage investors value startups
As we’ve mentioned, early-stage investing doesn’t quite follow the same valuation methods that traditional investors use for big, mature companies. (Forecasting future cash flows and discounting them to their present value? Not yet.)
Instead, here are a few common approaches that investors use when determining an early-stage startup’s valuation:
Comparable comp analysis
Investors review deals regularly, making them widely knowledgeable about how companies are being priced in the market.
This makes a comparable comp analysis — where an investor compares the financial performance of a company to other companies that have recently raised funding — a common valuation method. In the earliest stages, investors often apply a multiple to top-line performance metrics that are in line with multiples they’ve seen on recent deals.
If the range for revenue multiples for seed startups is 10-15x revenue, an investor may apply this same calculation to a company they’re valuing. It’s important to note that multiples differ based on sector, customer type, and technology, so investors will compare your company to others that share similar characteristics.
Scorecard method
The scorecard method is a simplistic way for early-stage investors to weigh the importance of varying factors that contribute to a startup’s success. This method is used for the earliest stages of fundraising and becomes phased out prior to a company’s first priced equity round.
Investors might categorize success factors by the market, team, or competitive moat, among others they deem important to a company’s growth. Then, the investor will score each section and calculate the blended result of all scores. This result will be multiplied by the median pre-money valuation of similar companies to find the valuation of the target company.
Zachary Ginsberg, founder and GP at Calm Ventures says, “At the seed stage, I’m primarily looking for a mix of credibility/competency of the founder/team, founder market fit, and different ways the investment has been derisked (could be via traction, IP, etc.), but no question I’m founder-driven at the seed.”
Reverse engineering ownership requirements
Lead venture capital firms have strict ownership requirements outlined in their limited partner documents. As a result, a lead VC might value a company based on the amount of capital the company is seeking and the ownership percentage the investor needs to acquire in the company.
For example, if Company A is raising $1M and a lead VC requires a 10% ownership stake for seed round companies, this would make the company valued at a $10M post-money valuation.
Exit multiple approach
Investors pay close attention to their potential exit size when they invest in early-stage companies. This is because most companies at this stage won’t return any financial payoff to investors. To make up for the vast majority of companies that shut down, a VC’s “winner” needs to return a very large multiple on their entry price valuation.
Elizabeth Yin, co-founder and GP at Hustle Fund reflects on the importance of thinking about exit multiples in her early-stage valuation framework:
“VC returns stem from multiples made on their money. And that stems from what is the multiple on the difference between the entry point and the exit point of investing. So for example, if I invest at a $5M post-money valuation, and if a company sells for $500M, then that's a 100x multiple in between.
Now, the actual money that I get back will not be 100x my investment because of dilution and so many other things, but that's the kind of multiple that VCs are shooting for. So for me, I am looking for this 100x, such as in this example, in the companies that I'm investing in.”
How does an investor’s target exit multiple impact how they value a company? Too high of an entry valuation, and it becomes more unlikely to achieve a successful exit.
“...most exits in a regular market are not over a billion and so that anchors me into companies largely under 10 million post-money.”
Other factors that impact early-stage startup valuations
Startup valuations don’t always stay consistent over the years, or even among similar companies. Both macroeconomic conditions and company-specific factors influence the valuation that investors will transact at.
How the fundraising environment impacts startup valuation
Like all markets, venture capital is highly influenced by the greater business cycle.
As the monetary system tightens, it becomes more expensive for companies to access capital. Investor capital becomes scarce and VCs are more picky with the companies they decide to invest in. In a looser monetary environment, VCs are more optimistic about the economy, and therefore, willing to invest at higher valuations. This means that the requirements and considerations for fundraising in a challenging market will differ from those of fundraising in a healthy market.
Which companies attract higher valuations
Early-stage companies can draw higher valuations when their founding teams consist of repeat successful entrepreneurs or founders with great experience.
Additionally, companies with strong traction or impressive growth are attractive to investors as they are often willing to invest at higher valuations given the early signs of progress.
There is no one correct way for investors to value early-stage companies. Instead, investors rely on a combination of qualitative and quantitative analysis, market trends, and exit projections to arrive at what they believe to be an appropriate valuation.
As a founder, understanding the core criteria that investors consider when valuing your company is a key component for effective communication and a successful fundraising campaign.
Tucker McKay