A graduate student from Norway e-mailed me about how high-potential businesses are valued during seed financing, since there is nothing really to base a valuation on — no sales and no cash flow. He suggested that any valuation seemed like holding a wet finger up to measure wind speed. The truth is, valuing a business during seed round is more like assessing wind speed by holding up dry finger in the air!
They answer to his question is this: they don’t really even try to value the business.
The most common approach these days for seed financing is to use a convertible promissory note. It really delays any need to value the business until there is clearer information to use for valuation. It is convertible at the time that Series A money comes in, usually from VCs, at some multiple over the share value at the time Series A money is secured. Series A round financing usually occurs when sales have begun, or at least a clearer picture of market potential is evident.
For example, let’s assume a start-up needs $1 million in seed funding. The investors issue a convertible promissory note with a 10% interest and with a 1.25 conversion multiple. So in effect, they give them a loan that can be converted to stock. At the time of the Series A round investment, which in this simple example is a $5 million VC investment one year later, the conversion occurs and they get shares that were equivalent to the $1 million seed money they originally put in the business times 1.25 plus accrued interest. So a year later the seed investors get shares that would be the same as if they invested $1,000,000 * 1.25 * 1.10 = $1,375,000. The logic is that by the time they are ready for Series A investment (in this case another $5 million) there is a clearer basis for valuation. They have begun to sell product, or they have a better idea on the size and scope of the market, they have time lines to product sale, etc. etc.
Seed money is most likely going to come from angel investors, angel networks, or small, boutique VC firms. The big boy VC firms will join in at the point of Series A or even Series B funding.
Dr Jeff Cornwall
Co-founder of The Entrepreneurial Mind, serial entrepreneur and professor of entrepreneurship.
How To Value High Growth Startups
Dr. Cornwall explains how angels value deals at the seed funding stage.
Yeah, but the problem with convertible notes is that they can create a conflict of interest between the investor and the entrepreneur: The higher the valuation at series A, the less stock the angel investor’s seed financing buys. In my experience, most Silicon Valley angel investors prefer to small series A rounds rather than convertible notes today.
Most post-money valuations seem to range between $500K and $3M depending primarily on product and customer milestones, ie, market and technology risk.
This is true. But many high potential start-ups have little negotiating power, particularly in markets outside of Silicon Valley where convertible notes have become the standard practice. In most metro markets there is little VC competition especially when compared to Silicon Valley.
No one ever said VCs were nice guys. They have found a way to protect their interests when doing early round funding and they seem to be sticking to their guns on this in many parts of the country. Let’s hope that your Silicon Valley experience with smaller series A starts to catch on in other markets.
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