Reasonable pre-money valuations for startups

On Thursday I was chatting with a seed-stage company from Dallas.  The founders have raised approximately $250,000 and are closing in on their beta release.  They are in the market for $2-3MM and are getting ready to start visiting venture capital firms around the country.  They asked me for advice on what pre-money valuation they should ask for.  They began talking about discounted cash flows and market comparables and my head began to spin. My advice: I suggested that if an investor asked them about valuation that they simply suggest that ‘valuation isn’t as important to them as finding the right partner.’  Then turn the question around, ‘based on your experience, what would you think was a fair valuation range?’  After meeting with several investors I suspect you will have a very good idea what the ‘market’ will bear for a deal like yours.

Of course, no one ever listens to my advice, so here are some things to think about:  The operable word, valuation, in the phrase ‘pre-money valuation’ is really a misnomer.  Typical angel or venture capital investors aren’t really attempting to determine ‘value’, but instead they are attempting to determine ‘price’.  This is an important distinction.  Consider the value of crude oil versus its price today - they have little in common.

David Berkus’ valuation method as described in Winning Angels suggests:

• 
  

  Sound idea = $1MM to company’s value

   

• Prototype = $1MM to company’s value

• Quality Management Team = $1-2MM to company’s value

• Quality Board = $1MM to company’s value

• 
  

  Product rollout or sales = $1MM to company’s value

   

The Ottawa Capital Network has an interesting explaination of price versus value:

More casually, “value” is what something is worth and “price” is what you get for it. Here are some of the reasons why the two results may be materially different:

• Fair Market Value is calculated in a “notional” market, while Price reflects the real world;
• Fair Market Value assumes equal negotiating ability between the parties, while Price is affected by different negotiating strengths;
• Fair Market Value assumes both parties have equal knowledge, while Price reflects differences in information or assumptions;
• Fair Market Value assumes there are no “special purchasers”, while Price may reflect the influence of a purchaser that has a unique incentive;
• Fair Market Value assumes neither party is under compulsion to transact while, in reality, vendors are usually under some financial pressure to sell, and one or both parties are acting on emotion; and,
• Fair Market Value assumes there are many buyers in the “notional market”, whereas in reality there are often only a few that often confer.

Notwithstanding this important distinction between “value” and “price,” most discussions on the topic inherently use the term “value” to refer to “price.”  Just remember though, all discussions on value really refer to price – i.e. what you can get for your company, not what it is worth. With the higher risks inherent with earlier stage companies, the valuation methodologies are much more subjective than the methodologies used for Later Stage companies.

According to VentureOne Research most seed stage pre-money valuations are between $2MM and $5MM with seed-stage investors receiving 20% to 30% of the company for investments between $500K to $2MM.  The Ottawa Capital Network explains how valuations are determined:

Given the relatively few possible outcomes, Seed Stage investors typically use very simple valuation methodologies. Some of the reasons for a more simple approach include:

• The final pre-money valuations will be within a narrow band and will be more affected by negotiating strengths than “mathematical” determinations
• Many Seed Stage investors recognize that much of the company’s business plan and product concept will likely change over the next few years
• With so much “uncertainty” and perceived risk, Seed Stage investors typically rely on more “intuitive” or subjective valuation models and support their subjective views with reality checks (i.e. due diligence) in a few key areas
• Seed Stage investors also recognize that, without a lot of substance in the companies upon which to do meaningful due diligence, they should be able to reach an intuitive assessment relatively quickly.
• Many Seed Stage investors recognize the “subjective” nature of their Seed Stage investment decisions and expect a high “mortality rate.” To offset this exposure, most Seed Stage investors are prepared to invest in one or two more financing rounds for the more promising investees.

Here are a few “data points” supporting the above summary observations:

• MIT Entrepreneurship Center: Research Findings February 2000: Seed stage technology ventures were typically US$500,000 to US$3 million. Pre-money valuations greater than US$5 million required an extraordinarily compelling story.
• The Tech Coast Angels: Website: “we look for pre-money valuations below US$5 million”, Presentation March 2002: “sweet spot” for investing is a pre-money valuation of US$1.5 million to US$3 million.
• Sand Hill Angels: Website: invest US$250,000 to US$2 million at a valuation of less than US$5 million.
• New Jersey Entrepreneurial Network Angels: Presentation: Valuation of US$1 million to US$5 million, for 20% to 30%
• Winning Angels, Amos/Stevenson (Noted Book): Most Angel investors want pre-money valuations between US$2 million and US$5 million, with US$2.5 million as the “sweet spot”