When you speak to early-stage founders they often don’t understand how they can either determine a reasonable valuation for their friends & family, seed, or Series A round, or judge if an offer they receive is “fair and reasonable.” There are a lot of moving parts to valuation and things vary across rounds. So let’s get into the details and also cover what typical numbers look like for these types of rounds.
I’ll talk about valuation issues in the order things come up. So we’ll talk about valuation and other factors at play during friends & family, angel/Seed, and Series A rounds. As you go further in the capital stack and as investors tend to be more professional, valuation and deal terms can and do change and I’ll make sure to point out the differences and pros and cons for founders and investors.
Typically friends & family investors are writing checks of $10k - $200k. Often they are family members or close personal connections who feel an attachment or affection to the founders and/or the problem the startup wants to solve. The normal valuations you’ll see at the friends & family stage is $500k to $1m. Typically the range is pretty tight and and the valuation is low.
The reason the valuation is so low is that the risk is enormous. Many people know that over 50% of startups fail so this is an extremely high risk investment. Sometimes you’ll hear these rounds called “triple F” rounds - Friends, Family, and Fools.
While you may have a great idea, the common expression you’ll hear is “ideas are a dime a dozen and it’s all about execution”... you very well could have a great idea but that’s just the beginning and it’s the execution that’s the hardest part. Founders usually think their idea is the “next big thing” and there is little chance of failure, but this just isn’t the reality and most investors know that. Even friends and family.
When friends and family investors put money into your startup it could be structured as a convertible note which converts to equity at a later stage, or it could be done as equity. By using a convertible note, you can DELAY the valuation discussion about what the company is actually worth. Again, a typical valuation at the friends and family “idea stage” is around $500k - $1m and often money is raised as a convertible note or SAFE. I’ll get into convertible notes and SAFEs in more detail in a bit as well as their interplay with valuation.
Okay, so after your “friends and family” round you’ll typically raise your Angel/Seed round.
Angel investors usually write checks ranging from $50k all the way up to $2m. But more typically, the check size will be somewhere between $50k-$200k with some variation higher or lower.
Often, angel investors don’t have a personal or family connection to the founders but may have an attachment to the problem being solved or have worked in the domain. Valuations you’ll see at this stage are between $1m-$3m and that’s usually for 10%-20% of the company. Again, like a friends & family round, oftentimes this is a convertible note or SAFE type structure that CONVERTS at a later round… a later, larger equity round that triggers a “qualified financing or QF” when you hit a “funds raised” threshold.
I’ve now mentioned convertible notes and SAFE’s several times, so let’s get into those as they have a very strong interplay with valuation. You’re about to see that valuation does not live in a vacuum. A point I’m going to come back to several times.
A convertible note (or convertible debt), is capital that begins as debt and converts to equity upon a next “qualified financing” round at whichever is less: the discount rate or the note’s cap. Discount rate and cap are super important terms to make sure you understand.
Convertible note investors are offered a lower price via a “discount rate” to the next round than other investors. This is when the convertible note investors' funds turn into equity at the next financing round. The most common discount rate you see is 20%. This discount compensates investors who come in earlier in the company’s life for the highly increased amount of risk they are taking.
We they have the valuation cap which puts a maximum “not to exceed” valuation on the company for the next equity round. Valuation caps offer dilution protection to an investor. The lower the cap, the better the deal an investor gets. For the investor, this prevents a “runaway” valuation where in the very early stage convertible note they took extremely high risk, and they want to make sure they can convert into a meaningful portion of equity in the next equity round. There are other important terms to understand about convertible notes but cap and discount rate are the most important ones.
When dealing with convertible notes, and taking that back to the subject of this video, often times that “cap” we’ve been talking about is the “tell” on valuation. If a startup says they are raising a seed round of $1m via a convertible note with a $10m cap they are implying a valuation of $10m. That’s a “not to exceed” number but is definitely a tell and the higher that number goes, the less interesting it is to the early stage investor. So keep that in mind.
There is one other very important and more flexible structure to talk about, and that is a SAFE - a Simple Agreement for Future Equity. This is a Convertible SECURITY, NOT a Convertible NOTE. A SAFE/Convertible Security has NO interest rate, NO maturity date, and NO repayment requirement.
SAFE’s are more founder friendly. Since it’s not debt, if the company would go under, the funds are not “owed” to investors. And similar to Convertible Notes, SAFE’s have discount rates and cap rates so you can still defer the full valuation discussion.
So now let’s think about the interplay of Convertible Note’s and SAFEs and the topic of this video -- valuation. Think about this… if you had an term sheet where for $1m convertible note (loan, re-payable) with a $5m cap and got another term sheet for a SAFE (convertible security, NOT a note or loan), with a $5m or maybe even $4.5m valuation cap, which offer would you take?
If they were the same cap, all other things being equal, you would want the SAFE since it’s safer for you (no pun intended). But if the valuation cap were a bit lower at say $4.5m (and all else is equal), you MAY still want to consider the SAFE so if things do go sideways, there is no debt liability. Valuation... does not live in a vacuum.
Before we go on, let me share a few more things you should seriously consider as you think about valuation for your startup. E.g. What happens with your employee stock option pool. Does it come before or after the financing comes in? So do just you, the founders, only get diluted when the stock option pool is replenished, or does the stock option pool get replenished after the funds come in so everyone gets diluted? This has an impact on what your effective valuation will be.
What other things are at play that are tied closely to valuation, but are not directly called “valuation?” How about… what additional rights or restrictions is the investor putting on the startup. E.g. If your startup wants to write a check or sign a contract over $20,000, maybe the investor has to sign off on that. You are giving the investor much more day-to-day control over your startup. You thought you were running the show. Maybe not so much based on other terms.
Another big factor in deal terms to think about… liquidation preferences. E.g., is the investor asking for a 2x liquidation preference? Meaning, if there is an exit the investor gets back 2x the money they put in before anyone else gets their money back. By the way, the typical liquidation you should be looking for is a 1x liquidation preference.
So, you might get an offer or term sheet with a slightly lower valuation but with more favorable terms regarding your stock option pool, liquidation preferences, and other rights. So the slightly lower valuation may be a BETTER overall deal for the founders and startup.
Last big issue I want to point out that we’ve seen bite founders in the ass and caught them off guard -- founder vesting. Let’s say you and your co-founder own 100% of the company. You are about to raise a Seed round, and investors are going to write a check for $1m. Investors want to make sure you are going to stay around so they are going to ask you to VEST into the equity of your own company. Otherwise they write a check for $1m, one of you walks out the door, and now owns a large percentage of the company that they are no longer working for. “Thanks gents for the cash and equity. Let me know how it works out!” Not something an investor ever wants to let happen.
What’s typical? Investors will ask you to vest into equity over 3 or 4 years. Some investors may say you get a 4 year vest, but you also get credit of 25% up front for the time you’ve already put in.
Investors will ask you to vest into equity over 3 or 4 years. Some investors may say you get a 4 year vest, but you also get credit of 25% up front for the time you’ve already put in.
Like I said many times before, the terms and negotiations can get fairly complex and when working on deals like this bring your A game and A team. Surround yourself with great attorneys or accountants who have done this before or other entrepreneurs or advisors who are highly experienced. And by the way, if your aunt is a personal injury attorney or uncle or friend is a divorce attorney and says “hey, I’m a lawyer, I’ll help you get the deal structured and done,” politely decline their offer and bring in that A team that has a ton of experience on these issues.
Okay… as we get closer to your Series A, I want to talk about how valuation becomes more mathematical based on some pretty standard ratios that are usually tied to one key thing -- how MUCH are you raising? In a recent Dreamit Dose we talked about how to figure out how much to raise. Often, this is a confusing topic for founders and they are not exactly sure how to figure this out.
Anyway… for early stage companies moving into Seed and Series A rounds your valuation is usually going to be a ratio based on how much you are raising. Typically an investor at this stage wants to own about 20% of the company. So if you tell me how much you’re raising, I’ll tell you, based on this ratio, what your valuation is.
If you are trying to raise a $2m seed round, I’m going to tell you that your valuation is going to come in at around $10m (20% of $10m is $2m). Now, that’s just a rough rule of thumb. Could you get a higher valuation? Sure. Let’s say this is your 3rd startup. The other 2 have been huge hits that drove great investor returns, and you’re working in a hot space with an amazing team and great early traction. Could you raise $2m at a $20m or even a $30m valuation? Sure. It’s possible. Not probable, but possible.
What you are working with here is “fair market value” and what the market is willing to bear. What’s the price a “reasonable buyer” and “reasonable seller” come to? If you go too high on your valuation and no one will meet it and you won’t get a deal done. Further… you could try to get a a bidding war going and get more than one investor offering a term sheet. So there is a chance the valuation gets bid up. But what we typically see at the Seed and Series A stages is that the 20% rule mathematically determines your valuation.
Now the final point I want to re-emphasize here is that valuation is JUST one of the many knobs and levers in a deal. Unfortunately, it’s valuation big issue many founders FIXATE on. They get “tunnel vision” about valuation and the thinking about how their Techcrunch headline will read. But be super careful here, otherwise you can get taken to the cleaners on many other terms (founder vesting, employee stock option pool, liquidation preferences, and other investor rights).
Keep in mind that at the end of the day, investors will typically set the cap or price, not you. You can try, but you may not be at the fair market value and may over or under price your round. Overprice and the round won’t close. Under price and you sold more than you needed to. The more investor interest you can generate, the better deal and terms you’ll get.