Valuing a Seed Investment

Hey JimbrowngoU,

I think your intuition is right about how seed investment valuation goes. I've only spoken to VCs about this and never done it before but here's what I've gathered.

The amount of the financing is dependent on milestones. The idea is to make sure by the time the startup runs out of the money, they'll have accomplished enough to justify another round of investment. So for a seed investment it might be how much money the startup needs to hire engineers and get a fully functioning product.

For ownership percentage, it's based on comparable term sheets. The VC will demand preferred shares and some other provisions to help minimize their risk. My knowledge of this is really fuzzy though because from what I understand, it really is just negotiations. Some factors would include:

*How many rounds of financing can the investor expect?? More rounds means more opportunities to get their ownership diluted. *How much value does the startup perceive of the VC?? The more the value the VC has as an investor (e.g. partners with extensive operating experience in a relevant industry), the more negotiating power *How many board-seats does the VC get??

I bet there is some 'set standard" term sheets that VCs and startups use as a reference for what is fair, but unfortunately I don't know the standards.

Ever hear of Google? First link for "vc valuation method" below:

http://www.entrepreneurship.org/Resources/Detail/Default.aspx?id=11040

Look into a fund called Foundry Group. They only take pitches via twitter and claim they don't even have excel installed on their computers. Oddly enough, they've had several serious exits and couldn't be anymore on point with their investments. Really really cool guys I'd give them a read.

I didn't read your original question carefully - my bad. Here's a link to various seed round term sheets that should give you some better background.

http://www.feld.com/wp/archives/2010/03/the-proliferation-of-standardiz…

Well originally what I was trying to say is not that a VC cares about what year nine revenues are but actually looking at the person and seeing if the guy (or in most cases, team) is actually capable of taking a business from $0 in sales to $100 mm in sales.

But I don't think VC's are insouciant towards revenue projections either. I was sitting in on a pitch of a medical device company. The company was in the middle of FDA trials and the partner asked the entrepreneur why he didn't have any pro forma financials. The entrepreneur said something along the lines of "well I don't think making pro forma financials with what are essentially made up assumptions has any value" and the partner was like "you should've had some numbers to see where the business can go".

I'm sure the entrepreneur found the partner's request just as ridiculous as you do but I'm sure the partner has his reasons (... guess I should've asked him why )

Anyways the $100 mm mark is something that I hear all the time. I think what's important is not that the business will hit $100 mm in year nine but that the market is large enough to make it believable that the business can do $100 mm in sales. So if the business is in a $500 mm market then it's highly unlikely that the business can reach $100 mm in sales since that would require 20% of the market. Now if the market is $2 billion then it's much more feasible. Of course, there's a lot more diligence required to verify these scenarios.

I see what you're saying -- I think we may be talking about different stages of a company. If a medtech company is in the middle of FDA trials, they should probably have some sort of revenue projection. I mean, at that point they essentially have a product and will be going to market as soon as approval hits, so they should have some form of financial model, or at least an idea of how many devices will be sold (at what price), cost of the devices, sales & marketing, R&D, and G&A (basically, their projection model should at least go through operating income). I'm talking about very, very early stage investing -- i.e. first and second rounds. When an investment is made to build the company out beyond two or three guys, hire personnel, etc. But I get your jist -- I think we're on the same page.

to the OP...its all negotiated...depends who (VC or entrepreneur) needs the other side more. For example, if its a hot startup with multiple term sheets, then they get a better valuation. Like someone said above, people also look at rough comparables, just to get an idea, and then negotiate from there.

Also, there are some general valuations used in the industry like for example, if its just you, maybe a partner, and an idea on your laptop, generally its worth 1-2 million. If you have already begun to build a product or service, and it works, around 3-7 million. If you have a product good enough to launch and maybe have some beta customers/registered members/pageviews/whatever, around 8-12 million. Varies from firm to firm, industry to industry, etc. This is just a rough estimate, of course you will consider tons of other factors to increase or decrease the valuation.

you should read this article from paul graham of ycombinator:

http://www.paulgraham.com/startupfunding.html

its mostly generalities with simplified examples and it doesnt fully answer your question directly, but it does give good background on the whole concept of funding in start ups.

and my interpretation of graham is that he would mostly agree with aceman above. this excerpt on valuation is taken from another one of this posts (albeit on angel investing, tho id argue its relevant given were talking about seed funding - which seems to mostly come from friends/family/angels/incubators) :

"There is no rational way to value an early stage startup. The valuation reflects nothing more than the strength of the company's bargaining position. If they really want you, either because they desperately need money, or you're someone who can help them a lot, they'll let you invest at a low valuation. If they don't need you, it will be higher. So guess. The startup may not have any more idea what the number should be than you do."

you might also consider how "sexy" the company is and the likelihood of success... sexy companies tend to be in high demand and they may have more than one VC firm that is willing to lend them capital - companies like this can negotiate better terms for themselves and vice versa... a company that has a very low probability of success, can be at the mercy of the VC firm

this is just a high level persepctive you may want to consider...

Allot of it is in management's knowledge of management, and their thoughts on if it's a good startup, results of diligence, etc.. VC's generally decide what their risk factor is, do some serious diligence on management's projections (most complicated part of "modeling-" these aren't simple revenue projections with growth rates. In my experience, we used different workbooks- one for cap tables/valuations, and one for the projection, which generally had about 10-15 sheets. The firm I worked at used pre/post money extensively, so it's still used. While they had an proprietary valuation method, I can't disclose that, but I'm sure other firms use the same.

In terms of pre-revenue companies, you never project 3-5 years out, way too far.

"Allot of it is in the ***VC Partner's**** knowledge of management,"

Jimbrown:

Simple answer: you cannot 'value' a seed stage venture. Unlike firms whose shares trade on a secondary market, your seed investment by itself affects the value of the venture. And to make that more complicated, usually value of venture before investment + amount invested