VentureHacks: setting valuation of a seed round

How do we set the valuation for a seed round?

April 17th, 2008

A reader asks:

"My question is how do we value a company with no sales? I understand it's an arbitrary valuation but is there anything we can possibly base it on? Is there a "default" valuation for companies in a seed round?"

We'll answer this question with some questions (and answers) of our own:

1. How much money do we need?
2. How do we set a valuation from this budget?
3. How do we express our valuation to investors?
4. What's the range for seed round valuations?
5. How low do seed round valuations go?
6. How much money can we raise in a seed round?
7. How much dilution should we expect in a seed round?

1. How much money do we need?

First, figure out how much money you need to run at least two experiments^*. Then tack on 3 more months of runway so you can raise another round before you run out of money. This is the minimum amount of money you should raise. For example, let's say you need $100K.

^* Your experiments should be constructed such that a positive result will let you raise more money at a higher valuation.

2. How do we set a valuation from this budget?

Now decide what percentage of the company you will sell for $100K. Pick a number between 10% and 20% of the company's post-money. You can go below 10% but that probably means your valuation will be too high or you will raise too little money.

For example, let's say you're willing to sell up to 15% of the company—that's your bottom line dilution. This implies a bottom line post-money valuation of $666K.

3. How do we express our valuation to investors?

Finally, tell investors that,

"We think we can make the company significantly more valuable if we raise $100K—that's our target. And we're willing to sell up to 10% of the company to reach that target."

10% is your aspirational dilution. It's the lowest dilution you can justify. It's the lowest dilution you can say with a straight face.

Notice that you didn't explicitly state your valuation. Combining the dilution (10%) with the amount you're raising ($100K) implies a post-money valuation of $1M. But the valuation is not explicit. This gives you room to raise your valuation if you raise more than $100K (and we suggest you raise as much money as possible).

4. What's the range for seed round valuations?

If $25K buys 1% of company, your post-money is $2.5M—that's on the high end.

If $25K buys 5% of company, your post-money is $0.5M—that's on the low end.

5. How low do seed round valuations go?

Y Combinator has set new lows for seed round valuations. They get away with it because they also set new highs for helping seed stage companies.

According to the YC FAQ, they buy about 6% of a company for $15K-$20K. So the post-money valuation of their investments is $250K-$333K.

But don't fixate on valuation. Low valuations aren't bad if you keep the dilution down too. 6% dilution is very low if the company makes a lot of progress with $15K-$20K.

6. How much money can we raise in a seed round?

If you sell 20% of your company at a $2.5M post-money, you raise $500K. That's about the maximum for a seed round. Beyond that is Series A country.

7. How much dilution should we expect in a seed round?

Take as much money as you can while keeping dilution between 15-30% (10%-20% of the dilution goes to investors and 5%-10% goes to the option pool).

Compare this to a Series A which might have 30%-55% dilution. (20%-40% of the dilution goes to investors and 10%-15% goes to the option pool.)

A seed round can pay for itself if the quality of your investors and progress brings your eventual Series A dilution down from 55% to 30% (for the same amount of Series A cash).

Don't over-optimize your dilution. Raising money is often harder than you expect, especially for first-time entrepreneurs.

Smart investors don't over-optimize dilution either. They want to buy enough points to own a good chunk of the company. But they want to leave the founders with enough points to keep them highly motivated to build a lot of value for the founders and investors alike.