As an early stage founder have you ever read news of a capital raise and wondered how one pre-product company can raise tens of millions of dollars (implying a valuation many times that) while others (maybe yours) hear they are “too early” or would be worth a few million at most?
It’s incredibly frustrating and I wanted to lift the lid on what goes into an early funding round valuation and hopefully make it a little clearer. To manage your expectations though, one of the reasons it’s so hard to understand is that value is so subjective, and
Ultimately a company is only ever worth what someone is prepared to pay for it.
But, here’s how we think about it at Rampersand.
For those looking for a detailed financial formula, some complex comps and DFC, a multiples-based rule sheet or a reverse engineered cost analysis — this is not the post for you. These may work in later stage or public market investments, but aren’t relevant here.
The valuation process has three components:
- Where is the business and management team today
- What is the ambition of the business and the milestones to achieve it
- Managing for founder dilution
Let’s unpack each of these:
Where is the business and management team today?
All investments are a function of risk-return. As a company is massively high risk, so the valuation is reduced. At the earliest stages of a company there’s absolute risk, particularly to people who don’t already know you and don’t have any insight as to your capability. You have no proven technology, product, commercial, management or any other relevant capability. Therefore the valuation is fairly low.
As a company progresses, it starts to reduce the risk. Prove you can build great tech — tick. Provide that there are customers who want to buy it — tick. Prove that those customers really love using it and come back for more — tick. As a founding team ticks off some of those factors the value of the business increases.
So when we’re looking at an opportunity, we are trying to develop an understanding of the capabilities within the business — what capabilities can be demonstrated (and therefore de-risked) and what leaps of faith are required to believe this team can build a multi billion dollar business.
Usually people think that means revenue, and usually that’s right, but revenue is far from the only proof of progress, and in fact often revenue can be misleading. At Rampersand we’ve seen businesses with millions of dollars revenue but very immature (i.e. high risk) engineering or go to market, and we’ve seen companies with tens of thousands of dollars revenue — or even no revenue — but are very mature.
And this is where, when looking from the outside, it seems so inconsistent and hard to understand: Risk is in the eye of the beholder. Have you ever spent time with people — founders, employees, investors — and thought, this person just gets it? They are brilliant, they are going to succeed, I want to be aligned with that person. That’s what we look for.
One of our jobs as an early stage venture fund is to see the opportunity and brilliance in things, sometimes even before the founders themselves. Sometimes the de-risking we see is simply someone’s passion for a problem. Other times it’s their unusual background, or their philosophy around testing and progressing. Maybe it’s just an insight into a problem or into a market that is unique and valuable. Below I talk about some of the evidence that investors typically look for to help de-risk a company or an investment, but it is subjective.
Summary: Understanding the capabilities of the team helps us develop a sense of the risk (or things still to be proven out) and therefore the value range of a company. Often those capabilities can’t yet be proven from the stage of the business, but are evident in the experience and attitudes of the team.
What is the ambition of the business and the milestones to achieve it?
The first is a threshold question: can this business be of a sufficient scale to build the value a VC investor is looking for.
The second question helps with two things: does the management team understand the process of building capability and sequencing of the business’ development, and what’s the right amount to raise now to get to the next material milestone.
This pairs the achievement of milestones together with de-risking…for example once you’ve proven you can build tech, you need to prove you can find a customer. Once you’ve proven customers love it, you can go ahead and find more customers.
Building a startup is fundamentally about understanding what is the next big step to achieve which then makes the following steps easier. Elite founders are able to understand the sequencing process well: identify and understand the problem, develop a potential solution, develop channels to potential customers, expand. At every step of the way they are listening, learning, refining and testing. Each step is an enabler of the next.
Together with the founders, we’ll seek to quickly get an understanding of where the company is at, what it hopes to achieve and what are the potential milestones along the way. We’ll look at what it may take to get there and what is the strategy to meet those goals, what will it cost to execute on the strategy and how long will it take to pull it off. From all that we’ll agree on the right amount of funding to execute the next phase of the plan (with a buffer) and not run out of runway before being in a position to unlock the next round (or to be in a position to not have to raise again).
It’s important that this notion of progress is not simply limited to revenue growth. What will drive real sustainable value, differentiation, defensibility, enhance the ability to deliver value to customers/users more efficiently and effectively than a competitor could, a 10x or 100x better customer experience. Revenue may be an indicator of these things, but is rarely the provider.
Summary: understanding the process of building the business and the foreseeable milestones forms the basis for determining the amount of money to be raised.
We believe that ideally founders don’t dilute more than 15%-20% per round of capital raising
Let’s say that the Founders own 90% of a company and other investors (angels, family members) own 10% and that the agreed raise amount, having gone through the process above, is $750k.
In order to derive a valuation that would involve a dilution of 15% for the existing investors (most notably the founders), we would use the formula below, which gives a post-money of $5m.
That gives a pre-money valuation of 4.25m. That means the new investors own 15%, Founders now own 76.5% and other investors 8.5%, as per the formula below.
Summary: once there is agreement around the right amount of money to be raised to unlock the next milestone, we can work backwards to develop a post-money valuation (i.e the pre-money, plus the amount raised) which then determines the level of dilution on the founders.
Hang on, that’s a little too simple, where’s the catch?
You’re right, there are a few things to be aware of that are really important.
The first is that actually the first couple of points above can take a bit of work and are subjective. We try and do it as quickly as possible, and always collaboratively (in fact it’s a great way for founders to test how the investor thinks, where they might be valuable and whether it’s a good match).
The other challenge is where it can be tempting to simply increase the raise amount and therefore increase the valuation. There are a couple of responses to this — firstly that agreeing the raise amount is subject to stage one and two (i.e. where is the business at in terms of demonstrable capability/risk and therefore a valuation range). And the other concept of real importance is capital efficiency.
What is the least amount you can spend to make the most amount of progress?
More money can lead to poor focus and discipline in business building, so the best thing is to have a system for testing and determining the key things to focus on (i.e. those that make the most progress).