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By Marco De Biasi

Without years of financial data to rely on, the process goes back to quantifying a bit of basic finance: ‘risk versus reward’. In startup terminology, it’s: ‘traction versus market size’.

At the early stage the value of the company is close to zero, but the valuation has to be a lot higher than that. Why? Let’s say you are looking for a seed investment of around $100, 000 in exchange for about 10% of your company. Your pre-money valuation will be $ 1 million. This however, does not mean that your company is worth $1 million now. You probably could not sell it for that amount. Valuation at the early stages is a lot about the growth potential, as opposed to the present value.

How do you calculate your valuation at the early stages?

1. Think about how much money you need to grow to a point where you will show significant growth and raise the next round of investment. Let’s say that number is $100,000, to last you 12 months. Your investor does not have a lot of incentive to negotiate you down from this number. Why? Because you showed that this is the minimum amount you need to grow to the next stage. If you don’t get the money, you won’t grow – that is not in the investor’s interest. So let’s say the amount of the investment is set.
2. Now we need to decide how much of the company to give to the investor. It could not be anything more than 50% because that will leave you, the founder, with little incentive to work hard. Also, it could not be 40% because that will leave very little equity for investors in your next round. 30% would be reasonable if you are getting a good amount of seed money. In this case you are looking for only $100, 000, a relatively small amount. So you will probably give away 10-20% of the company, depending on your valuation.
3. As you see, $100,000 is set . 10%-20% equity is also set. That puts the pre-money valuation between $500,000 (if you give away 20% of the company for $100,000) and $2 Million (if you give away 10% of the company for $100,000).

The right range positioning

That will depend on several things but in particular: how other investors value similar companies and how well you can convince the investor that you really will grow fast. In this situation a good solution could be setting ownership targets.

Many early-stage investors aim to own a particular percentage of a company with their investment. For example, an investor may want to own 20% of a company with their seed round investment and have an investment range of $250 to $500 thousand per deal.

Using these parameters, you can reverse factor the valuations they typically fund. In this example, the 20% would be based on the post-money valuation. Let’s figure out the range:

Minimum:

• $250,000 / (pre-money valuation + $250,000) = 20%
• pre-money valuation = $1,000,000

Maximum:

• $500,000 / (pre-money valuation + $500,000) = 20%
• pre-money valuation = $2,000,000

If you’re outside of an investors’ comfort zone, you may want to adjust your numbers or find another investor.

An Example: Facebook

Let’s look at one of their first investments as an example of how significant the valuation can be for the companies who achieve success.

In May of 2004, Facebook began serving ads on its site to generate revenue. That year, they generated $382,000 in revenue and raised $500k from Peter Thiel & co.at about a $4.5 million pre-money valuation.

Based on the actual numbers, Peter Thiel paid about 12 times on year-one revenue to invest. At the time, it’s likely that the targeted multiple used in structuring the investment was higher than this given the extraordinarily steep nature of the actual growth curve.

That $500 thousand investment yielded about a 10% stake in Facebook at the time of conversion to equity (the financial instrument was a convertible note rather than straight equity). At the time of Facebook’s IPO in 2012, Thiel’s $500 thousand investment was worth about $1,700,000,000.

You can see that each percentage point of ownership granted to Thiel at the end of 2004 ended up being worth about $170 million at IPO.