Seed Valuation Primer

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Where capital and opportunity meet

Company Valuation

A recent survey of managing partners of venture capital firms asked, “What is the most common
mistake entrepreneurs make as they try to raise money?” Part of the most common response
was, “Not understanding how to properly determine the value of their company.”

Determining the value of a start up company is extremely difficult, but there are some basic
principles all fund-raising entrepreneurs should understand and some tools they should know
how to use. Why is this important? If you were to survey professional investors, whether in the
stock market, real estate, precious metals, or private companies, the secret to success, you
might find the most common answer is “Buy low; sell high.” As the CEO of your company, it
is your responsibility to make your company more valuable, to allow your investors (including
yourself) to profit from selling shares in the company. If you do not intend to raise money from
investors, then you may not need to be concerned.

Key points to remember:

• Value is subjective and differs by perspective. Even seemingly objective numbers are
subject to interpretation or negotiation. If you’ve had to deal with an insurance company
after an auto accident or other loss of property, you probably learned the difference between
“replacement” value, “book” value, “fair market” value, “depreciated” value, “assessed” value,
etc. The check you received may not be what you expected. The value of your company may
depend on the value it represents to a potential investor or buyer.
• Ten percent of $50 million is worth more than 100 percent of nothing, or even $4 million.
Bill Gates owns less than 10% of Microsoft and is one of few inventors who succeeded as
entrepreneur who also succeeded as CEO of a large company.
• The goal of every company is to increase shareholder value. Every company starts off with
the same valuation: $0. The most valuable company, according to Fortune magazine in 2007,
was Exxon Mobil at $425B. Your company will fall some place in between.
• Every percent of ownership given to new investors comes from existing shareholders.

Pre-Money Valuation Defined

Like insurance companies, entrepreneurs and investors have different definitions of “value.” For
private companies seeking investment from outsiders, two of the most commonly used, and
commonly misunderstood, terms are “pre-money value” and “post-money value.” While they
are definitely related, they are not the same. In fact pre-money value PLUS investment EQUALS
post-money value.

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If you own a piece of land worth $100,000 then spend $200,000 building a house on that land,
in a simple world, the entire property is worth $300,000. What you started with, the land, is now
one-third the value of the whole asset. The new investment, the house, is worth two-thirds. This
is similar to how a private equity investment may work. If your company is worth $100,000 then
you raise $200,000 from investors, the company would be worth $300,000 after the investment is
made. You would own one-third of the company after the investors buy the other two-thirds with
their $200,000. This $200,000 is the “money” in the terms “pre-money value” and “post-money
value.”

Pre-money value: $100,000
+ Investment (i.e. “money in”): $200,000
= Post-money value: $300,000

Many home owners want to argue that, sure the tax assessor may appraise the total property
at $300,000, but I could sell it for more than that! Given the real estate market in recent years,
that’s probably true. But here’s the question – what if someone else spent the money to build
the house on your land and you sold the property together; how would you split the proceeds?
The simplest answer is to look at the value each contributed, assume the entire property
appreciated or depreciated together, and share accordingly.

Likewise, many entrepreneurs want to argue that their company is worth more than the $300,000
in this example. Assuming they spend the $200,000 from the investors wisely, the company
should be worth more than $300,000 … in due time. But, the point is to look at the company at
the time of the investment, which makes the math very simple: $100,000 + $200,000 = $300,000.

Another mistake entrepreneurs often make is to use the pre-money valuation to determine
the ownership percentages. Allow me to use different hypothetical numbers than above for
this explanation. With these new numbers, the entrepreneur retains majority ownership. If a
company’s pre-money valuation is $1,000,000 and an investor puts in $500,000 cash, then how
much does the investor own? Many people would say “half” because $500,000 is one-half of
$1,000,000. The investor put in half as much value as the entrepreneur. This is wrong. The
investor will only own one-third of the company because the formula is Pre-money + Investment
= Post-money. The post-money (i.e. the value after the money comes in) is $1,500,000 and
$500,000 is only one-third of that. The investor would own 33%, not 50%. Another way to
look at it is Yours + Mine = Ours. We need to know much “you” and “I” own of “our” collective
company.

Negotiations with investors

There are dozens of terms you could haggle over when dealing with investors. Liquidation
preference, conversion rights, anti-dilution protections, etc. In many cases, no single item is

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more important or more hotly contested than the value of the company. It is akin to salary
negotiations – the investor wants the CEO to have enough incentive to work hard, but does not
want to overpay. For investors, companies’ valuations also are like prices of goods. When you
buy fruit at the store, you need to know how much you get for your money. Assuming you know
you want to buy fruit and are hungry, price per pound is perhaps the only way you can literally
compare apples to oranges. The value of the company determines how much of the company
the investor buys with their investment. Prove this for yourself by changing the pre-money
valuation in the formula listed above, while keeping the investment amount constant.

The irony about a start up company’s valuation is that it really matters most when a company
turns out to perform only modestly. Of course, no one at the negotiation table expects that to be
the outcome. Instead, they likely expect the company to be either a huge success, or go down
in a blaze of glory. If the company does hit it big, then everyone should get very rich (or richer)
in most cases. While the difference between 55% and 65% of $100M may have a large real
value, the effect on one’s pocketbook or portfolio probably won’t be felt in the wake of getting
a windfall of $50M-plus. If the company is a failure, then you end up dividing a near-worthless
asset. But, if the company does “ok,” a few percentage points can mean the difference between
a net profit or loss on an investment, or between getting a decent payback on years of working
without a salary or having to explain to your family what you were doing all that time.

In the end, the other issues in term sheets glossed over above are designed to protect an
investor’s downside. Investors want to minimize their loss if things go wrong (which they usually
do in this sort of high-risk investment) almost as much as they want to maximize their gain on
their few winners. The division of a company (which is directly related to the valuation prior to
investment) is what determines how much of an upside the investor can realize when things go
well, or very well.

The survey of venture capitalist mentioned earlier found that there remains a major divide
between entrepreneurs’ valuation of their companies and outside investors’ valuation. What
does this disagreement mean? Should entrepreneurs value their companies lower? Should they
stick to their guns until investors agree with them?

Risks of Overvaluation
• First, you may not receive any investments if you ask for too high of a price. If you hold
steady with your price for too long, you may run out of operating cash and become so
desperate for investment that you have to eventually accept a valuation lower than you could
have received at the start.
• Second, an unrealistic valuation is a sign of an inexperienced entrepreneur. Most investors
put more weight in the management team than any other aspect of a new business. If you
start off showing immaturity, then you stand a good chance of turning off potential investors,
no matter how exciting your company itself is.
• Third, even if you do succeed in securing investment dollars (i.e. convincing someone
to invest in your company) you run a greater risk of dilution in later rounds. Subsequent

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investors don’t have to accept what previous investors agreed to. You may have to face a
“down round,” which is similar to when a public stock price goes down. People can buy more
shares for less money, but people who already have shares lose value or lose money if they
try to sell. You will have to decide between accepting these unfavorable terms or closing
down the business (after even more money and time has been invested than has been up to
this point). At best, negotiations with new investors can become contentious and may upset
your relationship with previous investors as well.
• Fourth, you may “get away with” inflated valuations if you can continue to find investors
who accept your numbers. This is easiest to do when you have either competition for your
company (i.e. multiple offers from investors) or can find less sophisticated investors. The
downside is that you may not receive valuable non-monetary assistance from your investors.
Oftentimes, the advice, contacts, mentoring, etc. investors provide is as important as the
money they bring in. Experienced investors can add tremendous value, and therefore may
“charge” a little more (i.e. demand a higher percent of the company).

Risks of Undervaluation
• If you “under price” your company, you may give up too much of your company too soon. But,
it is important to differentiate between giving up “ownership” and giving up “control.” Usually,
entrepreneurs are more fearful of losing control of their company than letting someone else
make more money than they will (although that can be painful to see happen too). You can
negotiate terms to separate control and ownership if needed. You also should keep in mind
that a small piece of a big pie can be worth more than a big piece of a small pie. Investors
are aware of the entrepreneur’s financial interests too. They should want the entrepreneur to
have enough incentive to keep working, struggling, and advancing the company. (Of course,
this may not be the case if the entrepreneur won’t add value in the future; if may be best for
the company to replace the CEO – but that’s another discussion.) If the founder/entrepreneur
feels they gave away too much and stands little chance of receiving financial satisfaction from
all their hard work, they may simply walk away and let everyone, including themselves, lose
the whole investment.
• If you resign yourself to a low valuation because you are desperate for cash, you could try to
protect yourself by raising less money. Raising less money at low prices could avoid giving
up too much too soon. However, you run the risk of running out of cash too soon. It usually
takes longer and more money to build a company than entrepreneurs expect, so starting off
with less money than you know you need can’t be good.

Commonly Used Valuation Tools and Methods

The big question is how do you determine the value of your company? There are a number of
commonly used methods:

Comparables (aka Market Value) – Look at other private investments or ratios such as price-
to-equity or price-to-revenues and apply to your company. This information is readily available

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for public companies, but more difficult to find for private companies. While other companies’
values may be useful for comparison, you need to adjust for various factors, or differences to
your company. For example, public companies have much higher liquidity. That means that a
stockholder (investor) can likely sell their stock at any time, even within a few seconds, if they
want to cash out for whatever reason. Investors in start up companies may have to wait for many
years to sell off their shares. Also, the risk that a large public company may go out of business
within a few months is much, much lower than the risk of a start up failing.

You may also use specific industry benchmarks that make sense, such as price per member or
subscriber. Various resources publish lists of comparables by industry.

Discounted Cash Flow (DCF) – One of the most common methods to value an established
company is to calculate its net cash flow over time, then determine the current value. For a
company that year in, year out, generates a million dollars in cash profit, it is relatively easy
to value this annuity. But, for start up companies that don’t have any revenues, this is much
harder. Any measure of cash flow is usually entirely based on projections, which are laden with
assumptions and seldom prove to be accurate. Even if your company has operated for a number
of years, you can’t assume steady numbers or even steady growth. You must be raising money
to pay for something that will change (improve) your company drastically. Past performance
really is not an indicator of future results because you are about to grow quicker than ever before.

Another issue with DCF is that even if you and potential investors agree to the projections and
terminal value, a key number to the formula is the discount rate (that’s why it’s called discounted
cash flow), which is the difference in value of $1 today compared to $1 next year, or in five years.
Investors would prefer a high discount rate (i.e. a dollar in five years is not worth very much)
and you would prefer a low discount rate (i.e. a dollar is a dollar regardless of when it comes in).
Investors discount future dollars highly partly because future earnings are uncertain and very
risky and partly because future cash inflows have to include expected returns on today’s cash
outflows.

While many investors have a good idea about a discount rate they like to use, negotiations may
involve a fluid mix of cash projects and discount rates in calculations that make sense to both
sides. Low cash values calculated using low discount rates may provide similar results as high
cash values and high discount rates. The result is that the negotiation over these numbers is
really a proxy for negotiation over valuation – how do we divide this pie? So this method doesn’t
really solve the question of valuation by itself. However, it does provide a possible guideline
using quasi-industry norms and a possible range for the valuation. Here are common discount
rates at various stages:

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Stage Discount Rate
Seed 60-70%
Early 50-60%
Mid 40-50%
Growth 30-40%
Late 20-25%

What this method provides, more than anything else, is a bit of a reality check for the
entrepreneur. If the DCF model results in a pre-money valuation in the range of $2M to $3M,
then you should not expect to be successful pitching a $5M company value.

VC Method – Venture capital firms have specific return expectations and goals. They also have
specific timelines within which they need to exit an investment. The VC method starts with these
two factors and calculates a value accordingly, based on a company’s projections (or the VC’s
own projections for the company) and a relevant multiple. Here’s how it works:

Start with the projected revenues or net profit in the exit year, often year 5. Let’s say revenues
will be $100M and profit is projected to be 10% of that, or $10M. Multiply one of these numbers
by an appropriate comparable to determine price, or value, in the exit year. If using revenue,
then you’d use a P/R comparable; use P/E if using earnings, or profit. We’ll assume the P/E is
determined to be a fairer comparable and use a P/E of 5 in this example. Earnings ($10M) x P/E
(5) = Value ($50M). The VC would then apply its discount rate to this value, which is usually its
required IRR (how much it needs to make each year, compounded, to generate its return goal)
to determine the required multiple over five years. If the VC seeks an IRR of 60%, that translates
into a 10x return over those five years. So, multiply the amount of money to be invested (how
much you’re raising) by this 10x to see how much the VC needs to receive in year 5. If the
company is raising $1M dollars, then this would have to grow to $10M (10 times $1M). This $10M
is the VC’s share of the $50M the company will be worth in five years. Dividing $10M into $50M
produces a 20% share for the VC. That’s how much they’ll own in five years, and is the same
they will own after they invest today (not including dilution from future rounds for this simple
illustration, which will have a material effect in real life). If $1M now buys 20% of the company
today, then the current post-money valuation is $5M ($1M / 20% = $5M). Remember, post
money valuation = pre-money valuation + investment, so the current pre-money valuation is $4M
($5M - $1M).

Net Asset Valuation – What is the value of your tangible assets? This method does not consider
the company’s performance or potential performance. This may make sense with a real estate
property, or a hotel chain that owns a lot of real estate, buildings, and other assets, but most
start up companies have few assets of value. Thus, this method is not very helpful for startups.

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Rules of Thumb – You can see how potentially complicated and arduous it can be to develop
full valuation models based on numerous assumptions, calculations, projections, and research.
During initial discussions with investors, they don’t have time to do all this work and often don’t
have computers with them to develop a complete spreadsheet. So, many have developed, or
adopted quick calculations they can make in their head on the spot. For instance:

Simple multiples: Value at exit = 1 x Projected Revenues in Year 5. The assumption is that
the projections are probably inflated, so any potential multiple is canceled out.

Regardless of what calculation investors use to determine the exit value, the next step
is to determine the current value. Investors can do this by inserting their own return
expectations and calculating a current valuation. For example, if an investor desires at
least a 5X return over 5 years (a 38% IRR), then the value at exit needs to be at least 5
times the value now. In other words, your pre-money now should be 1/5 or less of your
year 5 revenue projections. This is a simplified version of the VC Method described
above.

Value by stage: The average pre-money value of seed/startup companies is between $1M
to $3M, or between $2M and $5M, depending on the source of the study. Simple enough
to start negotiations, right? The upper end is reserved for experienced entrepreneurs
with truly unique opportunities. If you’ve made some progress and reached early
milestones, a valuation of about $2M should be received without much resistance from
investors. You should run your calculations for exits and returns using $2M as the pre-
money valuation to see if you would be happy with the numbers, and if investors will too.
If you are very early in your business, then don’t expect much above $1M.

Rule of “Thirds”: Based on a trend many early investors have noticed, this rule
states one-third of a new company’s equity should go to the founders, one-third to
management, and one-third to the seed investors (angels). If the founders are the
management team, then they can keep more (but allow for an option pool for future
executives hired). So, whatever amount you’re seeking from investors would then
represent one-third of the post-money valuation. Mathematically, this is the same as
saying your pre-money valuation should be twice the amount you’re seeking.

How much do you want?: Working backwards from the answer, if you are dealing with an
investor that targets a specific ownership percentage, and you know how much you need
to reach the next significant milestone (i.e. a step up in company valuation), you can focus
on a valuation that makes sense. In the simple example of an investor who targets a
50% ownership stake, then your company’s valuation should equal the amount of money
you are raising. This is similar to the Rule of Thirds, but allows for a broader range of
circumstances.

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Million Dollar Idea: Sometimes called the Berkus Method, after investor Dave Berkus,
investors start with a base valuation, and assign up to a million dollars in value for strong
performance or evaluation along specific attributes. For example, if the company has
(1) a very strong idea, (2) an existing prototype, (3) a quality management team, (4) an
established value-adding board, and (5) existing sales/revenue, then the investor would
add $5 million to their baseline. Any attribute that is less than stellar, or lacking, would
result in a lower valuation. This seems simple, but requires judgment along each
attribute (and different investors may have different requirements or weights/values) and is
thus very subjective.

Scoresheet: Investors may look at numerous specific aspects of your company to accept
or discount your proposed valuation. This can be similar to, but more detailed than, the
Berkus Method. Investors may assign points to each category then have a calculation
to determine a pre-money valuation. Or, it may be a tool to simply place your company
appropriately on a range of realistic values, such as the low or high end of the $2M to
$5M range of average seed stage valuations.

Negotiated Value – In the end, the only value that really matters. You may develop the
most robust model and perform intricate calculations to determine the precise value of
your company without a doubt, but it may all be for naught if you can’t close the deal.
What can you successfully negotiate? What is the investment market willing to pay for
your company? The market in the late 1990s was drastically different from the market in
the early part of this decade. Over the course of three years, similar companies would
have had dramatically different valuations. The only real “answer” to the question how
much is your company worth is what other people agree it’s worth. By performing some
of the calculations described above, you can enter negotiations with a solid starting point
and know how high or low you can go. The key is to be realistic and flexible.

Failure to Agree

After all this, what if you and your potential investors can’t agree on a value? One solution is
to discuss convertible “bridge” notes instead of equity. This is similar to “checking” instead of
placing a bet in poker because you wait to see what everyone else does before committing to the
round. It’s often called a bridge note because it helps your company across a gap to a specific
point, usually another, larger round of financing. The investors (let’s say their angels) loan you
the money, but have the option to convert their loan to equity at some time in the future. This
could be a set period of x months or x years, or as another event occurs, often when you close
the next round (from VCs, perhaps). Instead of declaring a value now, you agree to give these
angels some favorable value over the VCs. That could be a discount of, say, 10-20 percent. This
means that if the VCs invest at $1 a share, the angels can convert their investment/loan at $.80
to $.90 a share. Or, instead of a discount, you can give warrants at a specified price; they can
buy up to a predetermined amount of stock at that price, which should be lower than the current

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price ($1/share in this example). You get the cash now from the angels and they get a lower price
than subsequent investors. The biggest downside for the company is that it is debt, so you
may be required to actually pay it back, with interest. The biggest downside for the investor is it
limits their upside to some extent. With traditional seed round investments, they can see a jump
in valuation much higher than 10 to 20 percent to the next round. They may be able to invest at
$.10 a share, not the $.90 they get upon conversion.

A note about dilution: Dilution means a decrease in ownership percentage. A founder
starts off with 100% ownership of the company, but that gets decreased each time others
receive equity in the company. Investors also get diluted at each subsequent round. This
is a normal part of the fundraising process. Investors suffer abnormal dilution whenever
a subsequent round is raised at a lower valuation, called a down round. It is important to
both differentiate between the normal process and dilution caused by down rounds, but
most people refer only to the latter when talking about dilution.

According to PricewaterhouseCoopers/National Venture Capital Association MoneyTree™
Report Average Valuation Data by Stage of Development Rolling 12 Months Q1 1997
- Q4 2006, the average pre-money valuation for early stage companies over the four
years from 2003 through 2006 was $8.74 M. (Note this is based on VC financings, so
early stage does not mean seed stage, or angel round.) On average, investors in those
rounds received 40% of the company, leaving 60% for founders and seed investors.
Expansion round investors averaged a 23% stake, and later stage investors averaged
a 20% stake. After these rounds, founders and seed investors retained an average of
37%. If we assume that seed stage investors (not included in PWC/NVCA survey) take a
one-third stake, founders would be left with two-thirds of the company after seed stage.
Over time, that would decrease to 40% after early stage, then 31% after expansion stage,
resulting in 25% after late stage. However, the dollar value of founders’ stake would have
increase from about $2M to about $20M, on average. It is probably safe to assume the
founders likely would not have made $20M on average had they not raised the additional
money from investors.

Conclusion

Start up companies are full of promise for what could be. Start up companies are also full of
risk. After all, most companies fail while only a tiny percentage ever goes public. If you were
to perform an expected value calculation, multiplying the potential value of the company by
the probably of actually reaching that potential, you would find the value is not that high. The
key to determining the value of a company is look at what has actually been done, not what
may be done in the future. Thus, the key to negotiating a high valuation, and thus maintaining
a large percentage of your company, is to achieve as many key milestones as you can before
approaching investors.

Seed Valuation Primer

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