Valuation of start-ups is often considered more art than science by professionals and practitioners. The definition of value is one of the aspects that most concerns them and generates more uncertainties in the investment process in a start-up. Determining the company's valuation is a challenge for entrepreneurs and new investors.
In my opinion, the definition of valuation in the pre-seed phase is 90% Consequence and only 10% truth.
- A consequence of exchanging X of participation for Y of capital and not buying for an actual value/price.
- A consequence of the interaction between entrepreneurs and investors, and not a truth from valuation methods.
- A consequence of how they are creating the product, and not the existing product today.
- A consequence of “where” and "which market".
- But truth in market/user feedback about the solution and evolution to achieve the Product-Market Fit.
The structure of pre-seed start-up valuations in Angel Investing is a trilateral interaction of factors related to start-ups, investors and the external environment. The assessment at a primary stage focus on qualitative methods and the potential for evolution. In contrast, more data, values, and numbers are at a more advanced stage, which allows for a more quantitative assessment.
The pre-seed phase has a lack of historical data and the non-application of traditional methods. The angel investors sought to find innovative approaches to the traditional ones. Alternative valuation methods such as the options pricing method, the Venture Capital Method, the first Chicago method, and the modified DCF method already existed. However, for the angel investors and alternative approaches, the primary source of assessment is empirical evidence and comparison with other young companies.
Angel investors and valuation experts developed new methods for assessing the value of a start-up. Successful investors such as Bill Payne and Dave Berkus have created more elaborate methodologies such as the Scorecard Method, Berkus/Checklist Method, and the Risk Factor Summation Method. These approaches created by experts and investors take into account qualitative aspects, with a particular focus on critical factors that can determine the success or failure of a young company, such as the characteristics of the team, the market, competition, strategic partnerships, technology, patents, and others. In the end, these news methods and approaches always compare with other startups in the same industry, phase and local.
More than valuation methods and approaches, it is essential to create a relationship of trust between entrepreneurs and investors.
At the first meeting, Peter Thiel always asks entrepreneurs: "What important truth do the very few people agree with you on?". With this question, he can understand the differentiating factor of the startup and understand how the entrepreneur thinks.
When investors evaluate a startup in the pre-seed stage, they know that the product and the company will be very different soon. However, at the moment, they are evaluating the entrepreneurs and how they are addressing the solution to the market. The entrepreneur is not expected to have all the answers but to answer the right question.
This conversation between investors and entrepreneurs is not always fair game. For many entrepreneurs, this is the first time they are attracting investors, and the financial and finance concepts of entrepreneurship are new. Investors have, in their daily lives, the analysis of startups they have already invested in before. This way, it is possible to make direct and indirect comparisons.
To develop knowledge, startups need to talk to investors and the market to receive feedback. Feedbacks are an essential lesson for the startup's evolution and finding the ideal value for the pre-seed round. The most common is for the startup not to close the investment round with the same valuation defined before the first conversations with investors.
Building relationships and networks are essential. Fundraising expert Alejandro Cremades has an interesting quote about contacting investors: “Ask for money, get advice. Ask for advice, get money twice”.
The methods that can be used are standardised and highly dependent on subjective, variable and negotiable factors. As such, it is tough for the final result to be unambiguous. Even the most experienced and active investors often have conflicting opinions about the steady rise in valuations.
In this way, the valuation in the initial stages is the consequence of the relationship between the entrepreneur and the investor, and only at the end is the actual value discovered.
- Pre-money vs Post Money Valuation
Pre-money valuation refers to the value of the company before receiving the investment. The post-money evaluation refers to how much the company is worth after receiving the investments: pre-money value + invested value. Valuation methods always seek to evaluate the pre-money value, but in most cases, what determines the valuation is the exchange of X of participation for Y of capital, which produces the post-money
- Priced Rounds vs Unpriced Rounds
At the pre-seed moment, there is still the possibility of not defining a value for the investment. Instruments such as SAFE and Convertibles notes may allow the investment to be made based on a future valuation, however subject to a discount rate, among other conditions.
Investment term-sheets are twofold: Economic and Control. First, economic because it defines a percentage exchange for a specific value, and with this, it is necessary to define profit-sharing policies, among others. Still, it is also of control because it represents seats on the board of directors, veto positions, etc. Of course, the company's valuation has an economic character in this process, however, having a balance between these aspects can result in a lower valuation, but with a healthier agreement. Tightening the valuation rope is not always the most important thing.