Startup Q&A Blog Series: Valuing Early-Stage Startups

The Foresight team regularly spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. This blog deals with valuing an early-stage startup when dealing with seed investors.

Question:

How Do I Value My Seed Stage Startup?

A Foresight client was preparing for a seed funding round, and asked us the best way to value their business. Because early-stage companies lack operating history, and in a majority of cases lack any form of revenue, assigning value to the startup cannot be done with “traditional” methods such as a discounted cash flow analysis or a revenue “multiple” approach. The client is launching a smart wearable health tracking device, and looking to substantiate a $12M pre-money valuation.

Answer:

  1. Know the Current Market Comps

Because early-stage startups cannot be valued on cash flows, investors often turn to the market to determine the “going rate” for businesses in any given sector. This is where the entrepreneur should start as well. Undervaluing your business in negotiations with investors means you will likely give up greater ownership percentage than is necessary – something that should be avoided at any stage of the business, not just the seed stage. Conversely, overvaluing your business could kill the deal before it even starts. When both the investor and entrepreneur are educated on current market conditions, the starting point of valuation negotiations can at least begin in the same ballpark. The ColleyGO publication is a great resource for starting your market research. Below is a sample chart from this report:

Not only can we gather the median pre-money valuation for seed companies of which was $16,725,000 in 2024 according to this chart, but we can also observe trends in seed stage valuation over time. Various public sources are available for valuation research by country, market, etc. As a starting point, Foresight’s client knows that they within the median range with the targeted $12M valuation.

  1. Know What Matters to Early-Stage Investors

Although it is a great starting point, most investors will be a bit more sophisticated in their valuation process than simply taking the market median. In particular, there are certain characteristics of a business that investors will consider when assigning value to an early-stage company. In 2011, Dave McClure, founder of the accelerator 500 Startups, shared insights on his methodology for valuing such companies. McClure said that each of these 5 components of a business were worth $1M in value:

  • Market
  • Product
  • Team
  • Customers
  • Revenue

The value assigned to each point can change over time, and would probably be more than $1M today given the sharp increase in pre-money valuations since 2011.  Each investor has her or his own heuristics.

When developing your pitch deck for the seed round, it is important to keep these factors in mind, and highlight those that are strengths of your own business. If you have existing, brand name customers, make sure to call them out. If you operate in a particularly large or “hot” market, emphasize this and quantify it in any way possible. Our client happens to have a particularly strong founding team with experience working with and launching products in similar industries. This will be a great point to emphasize when negotiating for their target valuation.

  1. Efrat’s “Bonus Point”

One component that is noticeably absent from McClure’s list, and that is particularly pertinent to Foresight, is Intellectual Property. IP gives companies an inherent advantage over the competition, and as such, such advantages should be considered in the valuation of the business. Traditional valuation methodologies often overlook the true value of IP to a business – something that Foresight tries to combat. For this reason, entrepreneurs should be acutely aware of the business’s  IP value from the early stages and understand how it impacts the value of the business as a whole.

When considering your company’s IP and the value it adds to your business, make sure to consider all forms of IP,  not just patents. A granted patent is undoubtedly something to hang your hat on when negotiating valuation, but remember to also highlight things like a strong brand, customer relationships, trade secrets, customer data, etc. Even the potential to develop these strong IP assets is something to be considered for your pitch (for example, the potential of amassing customer data even though you may only have a small number of subscribers at this stage). With 2 design patents and 4 provisional patents, our client certainly has some increased leverage in the valuation discussion.

  1. Bonus Note for Hardware Startups

Hardware startups are still very viable businesses, although they come with a number of inherent challenges that software or service startups do not face. Because of this (and because hardware is not the most trendy space), some early-stage investors may shy away from hardware deals.

For those entrepreneurs dealing with hardware, Foresight recommends a few things. First, be creative when developing your business model. One of the main drawbacks of traditional hardware businesses is that revenue is restricted to a single transaction. Modern business models, like we see in software, integrate things like subscriptions or upgrade plans to increase the recurring nature of the company’s revenue. Second, think about how software can work with your product. Even something as simple as a mobile application can open many more possibilities for your hardware business (customer data, premium content, community building, etc.). Finally, be mindful of your audience when pitching your business. Knowing that the word “hardware” might raise some red flags, be creative in how you present your idea to keep investors engaged. For our client, we suggested simply replacing any mention of the word “hardware” with words like “device,” or “delivery mechanism”.

The Green IP Revolution

Governor Arnold Schwarzenegger recently celebrated over a report released by the Cleantech Group and Deloitte which showed that California’s clean tech companies received the highest venture capital funding in the second quarter of 2010.

“California has led the world in enacting policies that harness the private sector to create the clean and renewable technologies needed to combat climate change and reduce our dependency on oil. And our efforts are paying off, as illustrated by a wave of green innovation all over the state that is spurring investment and creating jobs. These numbers showing California is getting the most clean tech investment is just the latest example that we are moving in the right direction of building our green economy and creating a brighter, more sustainable future for us all.”

The report’s preliminary 2010 second quarter results showed that clean technology venture investments in North America, Europe, China and India, totaled $2.02 billion across 140 companies. For North America, California led the way with $980 million in investment, more than two thirds the total share. As the Green revolution heats up in the Golden state, we at Foresight are keeping an eye on what this means for innovation and IP. Entrepreneurs and business owners know the importance of ideas and intellectual assets, which are often the result of years of research and development. Their IP lies at the heart of their Cleantech company’s competitive advantage.

Late last year the Obama administration, with an eye on Cleantech being the growth engine for the economy, developed a pilot program to accelerate the examination of green technology patent applications at the U.S. Patent and Trademark Office (USPTO). We had learned earlier this year that the Kappos Administration has been heavily involved in streamlining the USPTO and this appears to be an area of particular importance. This is what Commerce Secretary Gary Locke said when the program was announced:

“American competitiveness depends on innovation and innovation depends on creative Americans developing new technology. By ensuring that many new products will receive patent protection more quickly, we can encourage our brightest innovations to invest needed resources in developing new technologies and help bring those technologies to market more quickly.”

The average examination time in the past had typically been 30 months for green technologies. Not only has the time frame for examination been accelerated, barriers have also been lowered for what qualified as “Green Technology” subject matter for patent applications pending before the USPTO. When the Green Technology Pilot Program was announced in December 2009, the program was limited to inventions in certain classifications in order to assist the USPTO in balancing the additional workload and to gauge the resources needed for the program. The USPTO has determined that the classification requirement is unnecessary because the workload has been balanced with other mechanisms, and the requirement was causing the denial of petitions for a number of green technology applications that would have otherwise qualified for the program.

The Program is available to the first 3,000 applicants and ends on December 8, 2010. The Patent Office estimates that approximately 25,000 of the currently pending patent applications meet the requirements needed to be classified as a Green Patent. To date, more than 950 requests have been filed by applicants who wish for their application to be eligible for the Green Technology Pilot Program. Only 342 of those have been granted, primarily because many of the inventions weren’t in classifications that were eligible. The lifting of the classification requirements is expected to allow many more applications to be eligible for the program. If interested, applicants should act quickly and carefully weigh the Program’s benefits against the requirements needed–most notably, claim limitations, abbreviated restriction practice, and early publication.

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