Reach out to Brett Calhoun, Managing Director & GP at Scale VC, at firstname.lastname@example.org learn about Scale VC and subscribe to our newsletter here.
In the last few years, it seemed like business valuation was a dying career for tech companies because no fundamentals or theories were being used. That said, at the Pre-Seed stage (i.e., pre-revenue or early traction), startups cannot fundamentally use the traditional valuation methods later-stage startups employ. Instead, valuations are based on the range within the market values of other pre-seed-stage startups. Investors generally communicate with each other on their valuation sentiment and leverage market comps through AngelList’s startup valuation tracker, PitchBook data and valuation reports, Carta data, or CBInsights valuation reports – although the market comps are somewhat lagging.
Although somewhat sheltered from market cycles, early-stage valuations are still affected by downturns as seen in Carta’s Q1 2023 Private Markets report. The range and median of the range are ever changing, which can create confusion for founders when going to the market. It’s also confusing when a founder receives a 409A valuation to set a price for their options pool that is 75% lower than that range. Founders need guidance that early-stage 409A valuations are not used to set a price in their round.
Although VC-backed startup and public company valuations have continued to drop, Pre-Seed and Seed valuations have stayed the same or even increased. Avlok Kohli, CEO of AngelList, recently said on the 20VC podcast, “You don't really hear of many late-stage deals getting done anymore. It's rare. And what's happened actually at the pre-seed and seed stage is all of the different investors that were investing later stage, some of them have started moving earlier and earlier, and so you just have a larger number of investors who have a lot of capital to deploy or are you gonna go, you're gonna go to pre-seed and seed. And so what you have is you have pre-seed and seed, they're buoyed, and we don't see that changing. We actually still see that staying the same and the valuation staying the same.” His insight matches the deals we are seeing at Scale VC, our conversations with other investors, and the data we are tracking. According to PitchBook, CBInsights, and Carta, Angel, Pre-Seed, and Seed valuations have continued to rise or stay flat from 2021 to 2022, whereas Series A+ has declined dramatically. CBInsights data shows Series B startups down a whopping 50%. The decline in deals and valuations for later-stage VCs has influenced them to invest upstream, maintaining the velocity and amount of capital deployed at higher rates.
Series A+ is based on valuation multiples, whereas Pre-Seed and sometimes seed is based on intangibles such as merits of the vision, founder-product fit, team/advisors, current market status, and perceived ability actually to succeed. The typical value at the pre-seed and seed stage is a spectrum ranging from $1M to ~$15M, and the valuation is based on how many and how vital those intangible factors are. A non-company factor affecting Pre-Seed valuations is the demand for early-stage investments (i.e., the velocity of dry powder being invested) and the size of the round (e.g., bigger rounds receive higher valuations due to dilution). At Scale VC, we look at the below intangible factors:
Founding Experience: A successful founding experience significantly boosts the value of a startup when a founder seeks funding for a new company for several vital reasons. Firstly, a proven track record of success inspires investor confidence, demonstrating the founder’s ability to navigate the complex entrepreneurial landscape and overcome challenges. Secondly, experienced founders possess valuable skills and knowledge from previous ventures, such as product development, team-building, and market strategy, which can accelerate the growth of their new startup. Furthermore, their established networks and connections within the industry can facilitate access to resources, partnerships, and mentorship. Ultimately, this combination of credibility, expertise, and relationships contributes to the higher valuation of startups led by founders with a history of successful ventures, as investors perceive them as safer bets with more significant potential for high returns.
Technical Skills: The ability to build the product for the problem founders are solving. Based on Super Founders, 50% of unicorn startup CEOs are technical, and over 70% of co-founders are technical, indicating that 70%+ unicorn startups have a technical founder. Having technical talent on the founding team has proven to increase the chances of having a billion-dollar outcome. The biggest problem with not having a technical co-founder is that, by relying on outside talent, the founder is highly limited in their ability to move quickly. If there is no technical talent on the founding team, the company will raise capital to hire developers or a DevShop. Lack of technical skill creates a chicken-and-egg problem because fundraising is challenging without traction, but generating traction without a product is almost impossible. Hiring a DevShop i) bleeds cash out of business and ii) creates long-term difficulties with transitioning the build in-house. The devshop is building the product on a contract basis; thus, the builder is driven based on the economics per project and not passion (i.e., solving their customers’ problems is not keeping them up at night.) In addition, some DevShops are naturally incentivized to take more time and therefore earn more money, which can create tech debt due to the lack of ability to build with future iterations in mind.
Domain Experience: Domain experience is not required to build a successful startup. Based on Super Founders’ data, only 45% of unicorn CEOs had domain experience, and only 30% of co-founders did. The downside of having domain experts on the founding team is their views on the industry are sometimes tainted due to coming from that industry. Those looking in on the outside have a fresh perspective on solving problems in that industry. At the same time, domain experts help build companies to solve problems they face within the industry, which allows teams to reach founder market fit. An optimal team would include a domain expert with a technical non-domain expert who is both passionate about the problem and possesses a shrewd understanding of the market dynamics. Domain experts generally have a strong network that facilitates quick access to customers, investors, talent, and an immediate sales pipeline.
Founder Institute breaks down the various funding stages below:
Valuing a pre-seed stage startup is a complex process that relies on multiple factors and methods. As startups progress through funding rounds, the valuation methods evolve to reflect the company's development. In this article, we'll discuss how pre-seed startups are valued, how valuation methods change as startups group, and the impact of different share classes and rights on valuation. Additionally, we'll explore the challenges of valuing pre-revenue startups and the role of venture capital (VC) investors in driving inflated valuations.
Founders need to be wary of the opportunity to take capital at high valuations because those valuations can set the stage for long-term failure. This means founders may never deliver on the high valuation, and there is a risk of raising at a down round, which historically blacklists founders. This seems like an unlikely pattern to change unless down rounds become socially acceptable.
At the pre-seed stage, startups are valued based on various qualitative and quantitative factors, including the sector, the founder's background, and technological innovation. Some standard methods used for valuing early-stage startups are:
Scorecard Method: This method involves comparing the startup to similar companies in the market, taking into account factors like the size of the opportunity, management team, and traction.
Venture Capital Method: This method estimates the startup's future worth and then discounts it back to present value.
Risk Factor Summation Method: This method considers various risk factors and assigns a weight to each, then adjusts the valuation accordingly.
As startups advance to Series A and later stages, valuations become more quantitative and may include the following methods:
Valuation Multiples: Investors may use valuation multiples such as Price-to-Sales (P/S), Price-to-Earnings (P/E), or Enterprise Value-to-EBITDA (EV/EBITDA) to compare the startup's valuation to that of similar public companies or exit multiples of private companies.
Discounted Cash Flow (DCF): This method estimates the startup's future cash flows and discounts them back to present value using a discount rate.
Intellectual Property (IP) Valuation: For startups with significant IP, the valuation may be based on the value of their patents, trademarks, or other proprietary assets.
Different share classes and rights can impact a startup's valuation. Preferred shares, typically issued to investors in later-stage funding rounds, often come with rights and preferences that affect valuation, such as liquidation preferences, anti-dilution provisions, and participation rights.
Valuing pre-seed startups, which are generally pre-revenue, can be challenging due to the lack of traditional valuation metrics. This has led to a "game" played by VC investors, where inflated valuations are passed onto the next investor in hopes of realizing a higher return. The abundance of capital in recent years has contributed to overvalued companies and irrational investing, especially during the pandemic. That said, at Scale VC, we believe the key to overcoming the hurdles of early-stage valuation is to stick to the first principles when evaluating and growing a business.