How much should I raise?
How expensive are your experiments?
In any startup, there are huge risks in your future. Your job as a seed-stage company is to identify the biggest risks and tackle them first.
Money doesn’t buy you a ticket around these risks. Instead, fundraising allows your team to build experiments that attempt to solve these challenges.
At LabDoor, the most expensive part of our early operations were, literally, experiments – analytical chemistry assays that we used to reverse-engineer dietary supplements and energy drinks. In our pre-seed stage, we raised $250,000 from local angels, friends and family. I used my own money as well. That money allowed us to build out our proof of concept – 100 simple LabDoor reports viewable on a web application.
At this point, we had seen 20K+ people use our product, were preparing to launch our first mobile application out of beta, and had clear customer metrics to guide our short-term product roadmap. We just didn’t have the cash or manpower to analyze new products or build applications faster — let alone spare a dollar for a marketing campaign.
The biggest risk for us was proving that consumers would actually use our products to successfully manage their health and safety. Our hypothesis was that if our applications could cover over 80 percent of product sales in the supplement market, and actively engage users at scale to add their products to a ‘LabDoor Cabinet,’ then we could quantitatively prove consumer demand for our product.
We worked backwards from there. I calculated the expected cost of the analytical testing, weighed the value of potential hires, and worked with my team to estimate our annual marketing spend. Then I added the cost of one additional startup experiment in each category (never go all-in on the first shot), and settled at a $750,000 seed round.
How much is my company worth?
Wrong question. Seed-stage valuation has very little to do with the actual liquid value of your company.
It has everything to do with the market value of the convertible note or equity document that you’re selling. Can you demonstrate scarcity in the market, led by respected investors? Who is begging for participation in the round, you or your investors? And what are market conditions in your startup community?
I would suggest finding a valuation that efficiently clears the market for your target raise. If you’re raising $1 million, review recent successful fundraises on sites like AngelList, and honestly assess your startup relative to these companies. Startups with built-in networks (like recent YCombinator graduates) will likely raise at a higher valuation. If you have no clear path to a lead investor, consider dropping valuation below the expected average. Remember, your number one objective here is simply to put money in the bank, so don’t stress too much over 0.5 percent.
If forced to pin down absolute values for 2013 Silicon Valley pre-money prices, I’d label $2-3 million valuations for weak seed rounds, $4-5 million for average seed rounds, $6-7 million for ‘hot’ seed rounds, $8-10 million-plus for all-star seed rounds, $20 million for Jack Dorsey (Twitter edition), and $40 million for Jack Dorsey (Square edition). And expect 50-100 percent discounts for any round raised outside the San Francisco Bay Area.
One Final Note
One of the biggest mistakes entrepreneurs ever make is to raise a round of funding at a valuation where they would be comfortable selling the company. At this point, your incentives will be horribly misaligned with your early investors, who are counting on you to bring them a 10x-20x return on their investment.
If you’re trying to make a $5-10 million company, don’t choose investors who are looking for $100 million-plus companies. In many cases, you’ll be better off bootstrapping to profitability with a simple product or service, and building out the company on revenues. (There is absolutely no shame in this – an exit at this range will instantly put you in the top 10 percent of entrepreneurs.)
A version of this post originally appeared on the author’s blog.
Neil Thanedar is CEO & Founder of LabDoor, a digital health startup that uses science to tell consumers what’s really inside dietary supplements. Before LabDoor, Neil founded Avomeen Analytical Services, an FDA-registered product safety laboratory, and also worked on emerging mobile sports and medical device products. He owns degrees in Cellular & Molecular Biology and Business Administration from the University of Michigan.
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Great points from the front-lines. Early stage fundraising is mostly all about burning through cash……errr “proofing the concept”, not creating, establishing,and growing an enterprise (there is no enterprise).
As a valuation professional to venture/PE backed companies (some early-stage start-ups), I concur that development activities/plans should drive the angel/seed raise. And given the extreme risks of an eventually successful exit(measured by using discount rates of 70% and higher), valuation of a “science experiment” at seed stage is a wild guess, at best. Consider also that a 15x return of $5M at 7 years equates to a return of 47% (but that casino odds are better).
Angel/Seed stage valuations (loosely defined) are often best estimated by the raise, (if a recent, arm’s length transaction has occurred) – via an implied calculation: 30% ownership of a $5M investment implies an “investment value” of $16.6M. However, these implied values are highly risky (as noted) – which suggests that if development milestones are not met, and if the start-up is not successful – (and most aren’t), then the valuation (investment) is only as fresh as the recent raise = cash in the bank before it is burned!
First-Chicago Methods might be of some use, which takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios, “Final Ownership Required = Investment / [terminal value/(1+IRR)^years)]”. The terminal value amount rqrs an estimate of terminal year earnings, which are highly speculative for start-ups.
I often answer the “how much is my start-up worth” question by responding: “probably not much”. And this is why..
1. Your great idea is probably not worthy of an investment. There are thousands of great ideas that are pitched to the VC community every year – only a fraction receive funding.
2. Of those, only a small percentage ever make it to a second round.
3. Of those, only a smaller percentage will ever see a successful liquidity event.
4. Think about the investment from a development-milestone perspective. Congratulations, you’ve written a business plan, obtained F&F financing of $300K, and think you have something “disruptive” — you and your MBA buddies/partners need seed money – this is the point where the real risks start, bc you will need to:
– Achieve proof of concept,
– Beta test the product or service,
– Successfully assemble the management team,
– Establish an ongoing, stable relationship with strategic partners,
– Obtain a sufficient base of customers to support ongoing operations, or obtain a key customer,
– Maybe obtain regulatory approval(FDA),
– Develop a manufacturing plan,
– Secure key raw materials, equipment, or work force,
– Deliver the product or service to customers,
– Achieve positive cash flows, or at least breakeven operations,
– Achieve profitability,
– Sustain profitability, grow market share, achieve scale ..and then maybe attract the attention of a larger competitor or strategic acquiror.
Keep your Company – IF YOU CAN – Bootstrapping to EBITDA milestones – and beyond is what most private companies in the US accomplish — without the need to exchange ownership. Yes, there is no shame in ‘not’ giving up 50% or more of your company in order to grow it into a market player.
I recommend: “Venture Capital and the Finance of Innovation”
A. Metrick & A. Yasuda, John Wiley & Sons, 2010