Seed Rounds: How To Pick A Valuation



I can’t tell you how many times I’ve had this conversation. A founder is about to raise their first round and asking me how to value their company. [1]

There’s a reason it’s so difficult to figure out - valuations have little basis in reality for early stage companies. You evaluate the team, product, market and other variables - then, make a general guess.

Before I go on, if you read nothing else, read this:

Your #1 goals is to get your company funded, so you can build a big business. Funding lets you invest in growing your company faster than revenue growth would normally allow. Do what you can to get your company funded and get back to work generating value.

Here are some ways to value your company:

1. Market size

A big market determines the upside potential. In a world where only the 1000x companies make back portfolios, this is really important. [2]  This can often justify a higher valuations - and for good reason. For some investors, this is the most important attribute and they won’t invest unless it’s a huge market.

2. Revenue

Revenue is how traditional businesses get valued. Early stage companies often don’t have revenue or have revenue so low, it’s not a real indicator of future potential. Companies like Facebook and Twitter didn’t figure out revenue for a long time. This is the main reason the process of picking a valuation can feel so ambiguous. With that said, if you have revenue, this is something you should emphasize.

3. Month on month (MoM) growth

To become a big company, you need high MoM growth for years (PG: Startups = Growth). 20% MoM growth is the gold standard - the longer and more consistent you hit high MoM growth, the better. Even a product an investor doesn’t fully understand - for example, an app that self-destructs the photos it shares - starts to look really good with high MoM growth. This works for revenue or active users.

4. Active users

Free, engaged users are a proxy for revenue, as long as you understand when a free user is valuable and when it isn’t. The threshold is generally higher for consumer startups (Ten million users is the new one million). Moreover, the engagement of your paid users are also important, even though they’re paying you, since it’s a leading indicator of churn.

5. Team

Everyone talks about the Stanford / MIT teams. It certainly can help boost a valuation, but isn’t necessary. Domain expertise can also help.

6. Valuations of other companies like you

Relationally, you can compare your valuation to other companies on Angellist, Y Combinator, 500 Startups or elsewhere.

7. Acquisitions of other companies like you

This is helpful in determining a valuation, since it shows real liquidity for what companies will pay for a company like you, instead of what an investor will pay to invest.

8. Raising momentum / high demand

This method of valuing a company is further from reality than most attributes. If your company is in high demand, it drives the potential valuation up. Hopefully, it’s in high demand for good reasons, otherwise you risk a down round in the future.

9. Accelerator

Being part of an accelerator can help your valuation, since you’ve at least been partially vetted, which decreases some, but definitely not all, of the risk.


Things to note about valuation:

1. Your outcome will likely be binary

I spoke to a YC class about fundraising a few years ago and I still believe this - I’d rather raise $1m at a lower cap than $100k at a higher cap. The former will get us to the next stage as a company. The latter won’t be enough money to grow and without the capital to grow, could risk failing or a down round.

2. The valuation only exists if investors validate it

Traditionally, there’s a lead investor that validates a valuation, but a lot of companies now raise without a lead. By getting a few investors to buy in at a specific valuation, they’re effectively validating the amount. Either way, your valuation doesn’t truly exist until it’s validated.

3. Don’t risk a down round

A down round happens when the valuation of your next round is less than your current round. No one comes away from that undamaged. That can happen when people are too aggressive about their valuation in that first round. Don’t let that be you.

4. Terms often matter more than the valuation

For a higher valuation, you may be giving up some control, like a board seat. I’ve also seen people raise on 2x+ pro-rata, which means that the investor has the option of doubling their stake in the following round, which I think is generally a bad idea. I’d keep your terms as clean and standard as possible. [3]

5. Valuation pride

Why do people push super high valuations? It’s one of the few moments in your company’s history where you can get a stamp of validation. Just like good grades or good schools help drive your self-worth, a great valuation can do that too. It’s something you can tell others or use to compare. So, the bigger the stamp, the more likely you’re seemingly doing well. Don’t be tempted by this.

6. Map out multiple stages of financing

Take a moment and project out your equity over multiple rounds of financing. You need to make sure there’s enough equity to sell, while keeping enough equity for the founders and team. I hear of companies that sell 50% of their company for a few hundred thousands dollars. That won’t leave enough equity to sell for future financing rounds. (The Benefits of Building a Company in the Bay Area)

7. Drive for a ‘fair’ valuation

That probably depends a lot per company, but I kept that word in my head as I figured everything out.  

8. Make sure your valuation doesn’t exclude great investors

Even though it’s hard to know an investor’s value add in advance, make sure you’re not picking a valuation that prevents great investors from investing (Investors and advisors: the crowd, the ringside, and your corner). Note, if it’s a great company, not all great investors will walk away from a high valuation (Sam Altman: Upside risk).

9. Be nice

Invariably, you’ll run into investors that think your valuation is too high. The only right behavior is to be consistently nice and explain your thought process (Treat investors well when fundraising).

10. Valuation versus percentage ownership

Some investors are more interested in the percentage of the company they own, versus the valuation. In that way, you might end up with a higher valuation than you would have had otherwise. You can certainly take this approach to picking a valuation, but just make sure you’ll be able to at least grow into that valuation - preferably grow significantly past it - by the time you raise your next round.

You’ve probably noticed at this point that there’s no clean formula. Even though it’s inexact, investors will want to know the thought process behind the valuation you pick.

Certainly, there are bad valuations, but there’s a larger range of gradations of good valuations and I wouldn’t stress about small differences between the gradations in the good range.

Good luck figuring this out. The key is to not spend too much time thinking about it. Some incredible companies, like Dropbox and Airbnb, got valuations that would seem extremely low in this market for their first rounds.

In the end, it’s your ability to execute that will turn your company into a big one - not your valuation. It’s more important to close the round, get the money in the bank and get back to building.

Would love to hear what you’ve learned about valuing early stage companies in the comments.


[1] This is mainly about your first round. I think a lot of the lessons can apply to later rounds though.

[2] Articles on needing the companies with 1000x returns to justify your portfolio:
Black swans
Upside risk

[3] YC has standard docs you can use. 

Photo credit

This email may be worth millions of dollars in sales

We were comparing two SaaS applications. One gave us a better quote, so we asked the second if they would match it. They wouldn’t, but their founder, wrote us an email explaining: 

  • Why their software is better
  • How their software would save us a lot of money and time 
After reading it, we immediately picked the more expensive choice.  I thought the email was so compelling that I wanted to share it as a great example of how to position a product for value vs. cost.  I've anonymized the company: 

Subject: Re: demo follow up

No worries...  short answer is no, we aren't able to compete on price against FooCorp.

The FooCorps's of the world have spent a couple decades now in a the race to the bottom and it shows.  I have no doubt you can get their product (or a whole raft of others) for a few bucks cheaper than us.

Our product, Acme, is different.  We're designed to help improve your'e company's performance in the critical area of XYZ.  The ROI on doing that is enormous.  

Now, not every organization sees the value in investing in XYZ.  I get that.  But if yours does, Acme is one of the most leveraged investments you can make.

Assume HelloSign does 5-6 transactions in the [XYZ field], that's going to run 300-600k per year (so figure this is a $1-2MM investment over 3 years).  The value of each transaction will be maybe 2-5x that if they're done well, whereas a bad one we know can actually destroy value.

On the cost side, great transactions churn over at less than half the rate of low performing ones - which means if you do a better job at XYZ,  you'll save 10's of thousands in new transaction costs as they stay longer.  And on and on....  

So ultimately if you think Acme will help you do this better - even just a little bit - the whole thing is peanuts.  The cost difference between our product and the others, even less.  

Look, FooCorp's customers are switching to Acme in droves because we're investing heavily in great customer service and innovation.  Those things cost money but, as we see above, they drive tons of value so the market is happy to pay.  

We'd love to have HelloSign on board as a customer and I'd be happy to have another chat with you or them if you think it would be useful.  Let me know!

Regards,
Acme CEO

The point is, instead of doing a price cut, it may be worth explaining why your product is worth more. This email will probably be worth millions of dollars over the lifetime of their company. 

Either way, he was right. The minor different in price was worth it. The product is amazing.

The Benefits of Building a Company in the Bay Area

move your tech startup to the Bay Area

In 2010, I moved myself and the company from Minnesota to San Francisco. There’s no way we would have been able to build HelloSign in Minnesota.

Every week or so, I hear about a new city that’s trying to become the ‘next Silicon Valley’ or someone explaining to me that Minnesota is a great place to build a tech company.

You certainly can create a good company anywhere. You can also sprint at 20,000 feet. It’s just significantly harder and you’ll be giving yourself a handicap.

If you'd like to see this topic discussed at SXSW Interactive, vote for the panel in the SXSW panel picker. 

Here are seven reasons I moved:

1. Capital

There is a unique ecosystem of angel investors and venture capitalists in the Bay Area. It’s unparalleled for tech companies anywhere in the world.

Over the past 40+ years, the large exits and IPOs (Facebook, Google, Yahoo, eBay and more) have fueled and justified the next funds at VC firms. And they've produced a new batch of rich individuals who’ve become angel investors.

It’s this group’s unique understanding and affinity for tech that has helped produce incredible returns on investments -- which in turn has justified more capital entering the ecosystem -- which have in turn funded more great companies and so on.

We raised capital in the Bay Area in 2011. While we were fundraising and bloggers were calling the environment ‘frothy,’ the Minnesota Star Tribune wrote a long article about how angel investors in Minnesota were cutting back. These are two very different worlds.

2. High concentration of specialized knowledge

Knowledge is almost just as valuable as capital. Within walking distance of our office, you can talk to the people who built Twitter from the ground up and experts on viral growth. Want to learn about SaaS metrics? Reach out to the companies that set the SaaS standard -- like Dropbox, Box, Evernote and others. Even with their level of success, these people are remarkably open and accessible.

3. Culture of risk

My cofounder quit his full-time job at Tripit to take a risk building this company. In Minnesota, I’d be hard pressed to get anyone to quit their job to join a risky startup. Since there’s a lack of capital in Minnesota, starting a company is significantly harder for anyone with a family or any other life expenses.

3. Valuations

Valuations are significantly better in the Bay Area. Since there is a super high concentration of billion dollar tech companies, the returns justify the higher valuations. As one investor explained to me, it’s the Facebooks, Googles and Dropboxes of the world that make this possible.

Moreover, there is a high concentration of investors competing for the best deals, which produces a better market price on equity. Certainly, a too high valuation can also be harmful, since it risks a down round. With that said, over the course of multiple rounds, you need to maintain enough equity to fuel growth. If you sell too much, too early, it can stunt your future growth potential.

Outside of the Valley, one founder explained to me that it’s not uncommon to sell 50% of a company for a few hundred thousand dollars. If it’s a capital intensive business, it’s unlikely they'll have enough equity left to sell in order to make it into a big company. Investors, getting too much of a good thing, get a bad thing, which prevents their portfolio’s ability to grow.

4. Legal terms

It’s not uncommon to see companies move to the Bay Area and be stuck with crazy investment terms from a previous angel investor.

Let’s say an investor who’s invested $10k has the ability to veto an acquisition. Not only do custom terms cost a lot of money in extra legal costs, it can also scuttle a company’s ability to raise future rounds, since this small investor has an outsized impact on the future of the company.

Because of the sheer number of deals that happen in the Bay Areas, norms on what is reasonable and not reasonable have developed.

5. “Trust-based ecosystem”

Garry Tan explained to me once that Silicon Valley is a trust-based ecosystem.

Just like repeat interactions in the prisoners dilemma produce better behavior, so do repeat interactions in Bay Area. Founders and investors know that if they behave badly, they’ll get cut out of great deals in the future.

6. Community versus isolation

Ben Horowitz explains that the most difficult job as a founder is managing one's own psychology.

In Minnesota, no one understood what I was doing or why it was worth it. I constantly felt like a foreigner. I even remember demoing our product to a family member and the person just walked away. The day I moved out here, I demoed it for a friend - he was so enthusiastic about it that he then started introducing me to his friends. After working on the product for nine months in Minnesota, I never experienced that level of enthusiasm from anyone.

Starting a company is hard and doing it in isolation is even harder. In the Bay Area, you’re surrounded by a community of people who understand. That makes a huge difference when you’re building a company.

7. Business development and integrations (growth)

This is a huge source of growth for us.

The vast majority of the companies we work with are within driving distance. In the event there’s an opportunity, we can meet in person. I’m very confident that business development wouldn’t have been a source of growth from Minnesota. Here's a talk I gave last year at 500 Startups unSEXY conference about business development.

It’s hard to evaluate odds. Especially with outliers and a desire not to move. Groupon was based in the midwest (Chicago). Startups are generally binary. So, anything you can do to stack the odds in your favor, you should do. If it takes moving to the Bay Area to increase the chance that you’ll succeed, I would (and did) do that.

There are 33 more reasons to move, I just ran out of time. Vote for the panel and share your comments on SXSW Interactive's panel picker and I'll share more reasons to move! 


Photo credit

Setting your angel round up to fail

I emailed this to one of our investors in 2011. Fundraising felt like I was playing t-ball with pros. (photo from wikipedia)


I met up with a founder that was raising an angel round. He was actively raising, but was only having a few investor meetings a week.

I mentally ran the math (# of potential investors, amount they could invest, potential conversion rate and time allocated) and there was no way he was going to close the ~$1 million round he intended.

Indefinite raising is also a negative signal. Just like a house that stays on the market too long, deals get old and become increasingly less likely to close.

Here are some checks to make sure you don’t set up your angel round to fail:

1. Do the math

  • Number of investors you’re pitching
  • Range they'd invest (i.e., $25k - $50k, $100k - $200k)
  • How many people you could close - run several conversion scenarios

If you need a 100% close rate to fill 75% of your round, it won’t be enough. It’s highly unlikely you’ll be able to get a 100% close rate. Many investors passed on Dropbox and Airbnb.

Need to talk to more investors? I wrote a post awhile back that could help: 10 Places to Source Investor Meetings

2. Target a 1-2 month raise. No traction? Stop raising

You want to find out as fast as possible if your company is fundable or not. Consolidate all of your learnings into as short of a time period as possible, so if you’re not getting traction, you get back to work. Remember, it’s the work you do on your company that makes you more fundable - and permanently fundraising can prevent you from creating any value.

If it’s obvious you’re not getting traction, stop. It’s not only a waste of time and a company that raises indefinitely is a negative signal.

4. Have > 6 months runway when you raise

Make sure you have 6 months of runway left before you start fundraising. The number of founders I meet that don't know their runway is terrifying. (Don’t be the startup that accidentally runs out of money)

With > 6 months, you have a few months to raise, while also running a backup plan, which may be profitability or an acquisition. If you wait until you have 1 month left in the bank, you run a huge risk that your company will fold; if you do find investors, the terms will likely be bad because your BATNA is going under.

5. Set your minimum target carefully

Many founders give a range of how much they’d like to raise. For example, targeting $300 - $500k, $750k - $1m or some other target range.

What founders don’t realize is that some investors consider getting to the minimum as part of the investment deal. Investors may commit, but if you’re raising $300k and only get to $200k, they might not transfer the money. If you think about it, that logic sort of makes sense, since your company will need the capital to execute on the plan you pitched. They may want the money to be held in escrow or wait until for confirmation that the minimum amount has been transferred.  

Other investors won’t ask and will transfer the money immediately. For those that asked us, we sent a screenshot of our bank account to confirm that we hit our minimum.

6. Don't be sneaky

Sometimes I meet founders that try to game the fundraising process. One of our advisors explained that investors are pros at fundraising. They do this all the time. Founders rarely do fundraise. I always felt I was playing t-ball against pros - I sent that t-ball photo to one of our investors to show how it felt :).

It's unlikely that you'll out game or out maneuver anyone.  By trying, you may just end up burning bridges and scuttle a relationship that should be built on trust.

The solution is simple: don’t try to game anyone. Just be nice, honest and straightforward about what you're doing and try to find good partners.  (Treat investors well when fundraising)

7. The valley remembers

I heard Garry Tan say something that stuck with me - Silicon Valley is a trust based ecosystem. That’s great for people that are trustworthy, not good for people that aren’t. So, be the former.

If it seems like you’re setting your round up to fail, the good news is that you can fix those issues or just focus on building out your business. You can still build relationships with investors, but explain that you’re not fundraising - you’re just looking for advice (Meeting with Busy People). In the end, it’s a combination of good relationships and a good business that will help you get funded. [1]

--

[1] There’s always the pre- launch, post launch debate on fundraising. If you're a new founder, raising pre- launch is more difficult. You can pull it off, I just think it's harder. Just know when to stop raising if it’s not working (see #2 above).


Too much funding, not enough action

People often advise raising more than you think you need. Years ago, we raised double what we intended and it had a hugely positive impact on the company. (Investors and advisors: the crowd, the ringside, and your corner)

Yet, I’m starting to see a downside of too much capital: new founders with years of runway and no external pressure to perform. Imagine a team that:
  • Raises a lot of money (3+ years of runway)
  • Doesn’t focus on revenue and / or engagement
  • Hires haphazardly
  • Doesn’t have a board or external pressure [1]
  • Doesn’t run projections (Don’t be the startup that accidentally runs out of money)
  • Doesn’t execute on a plan or build deliberately
The common outcome: unnecessarily long development cycles both pre-launch and post launch - often building without any strategic vision.

This is startup purgatory, which is working forever, building for users that might not exist. Then, if they do exist, they may represent a vertical too small to support your company. (Don't build a Galapagos product)

It’s only when the founders discover that their runway is finite that there's a race to the fundamentals, like active users or revenue. They plan better and iterate like crazy. There's nothing like finite runway, diminishing cash and uninterested investors to focus on core business fundamentals.

Extra capital can significantly de-risk a company. It helps to take it. But, it can also lull you into a sense of complacency. If you have the capital, think hard about how you can put it to work.


[1] There’s a lot of aversion to having a board because there are a lot of stories of bad boards. I found it really helpful. We have a meeting every 2 months and discuss company goals, objectives and accomplishments. There’s nothing like announcing commitments to make sure you keep them.

Join team to solve the VA's tech problems

Stephen Levy recently wrote about a team of YC alumni, Google and others to help fix HealthCare.gov. They've made a huge impact. 

Dan Portillo, from Greylock, is now helping put together a tech team to help the Veteran Administration (VA). My brother is a veteran and he ran into a lot of issues at the VA. It was so frustrating, he ended up buying private insurance instead. If anyone is buying private health insurance instead of using the VA, which would be free for veterans, something is fundamentally wrong with the system. 

Picture of my brother in Afghanistan a few years ago. 

Here’s the details that Dan recently sent out. 
Over the last couple of weeks I've been talking to Todd Park and Jennifer Pahlka, White House CTO, and Deputy CTO respectively, about putting together a team to help address the technical issues around the Veteran's Administration, I'm sure you've read the news about how people have been dying waiting for treatment. Program would look a lot like the healthcare.gov rescue. I was trying to see if I could take 3-4 months off from Greylock to work on it, but it's just not possible right now. There are a couple things I would ask the group to try and help.

1. They need a talent leader who can help bring 20 or so folks, mix of professional services, design, engineering, data scientists and SREs. They'd also be working with companies like Facebook & Google who are looking at donating developer time to. Person should be pretty senior and be able to identify the right ICs and leaders.

2. Helping the come up with the 20 people who will actually be doing the work. Positions are paid, but they're in the 100-150 range, so the right person will probably already have made some money and want to work on something meaningful.

Happy to talk to anyone who's interested in learning more. Dan 

Let me know if I can put you in touch. This is a problem worth solving.

Spooking potential hires

“I refuse to join a club that would have me for a member” - Groucho Marx


We were interviewing for a role and had already talked to 30+ candidates. If we talk to 30 people, you can imagine how many resumes we looked through and phone screens we did to get there. 

We finally found someone who was a great fit. 

Instead of going through the entire process, like we normally do, we skipped one of the final interviews and moved to make an offer. Ironically, we just ended up spooking this great candidate. 

The candidate didn't see our huge filtering process and level of due diligence. They didn’t see how much effort we put into every single hire. They didn’t see how many people we talked to that we didn’t bring on board. 

All they saw was a company that seemed to make quick decisions, without enough reflection. If we had continued our normal interview process, they would have seen our high level of diligence. 

Great candidates want to join great teams. They don’t want to join companies without a strong filter, since they’ll end up with subpar coworkers and a subpar company.

This candidate didn’t end up working out. But, we fixed our process. No matter how good a candidate, we stick to the process, so they can see how much effort we put into making sure every hire is a great fit.

Hire every position at least one month early

HelloSign had a big spike in support needs awhile back. The growth was great, but at the time, we didn’t have enough support people to meet that growth. Since we’re committed to closing out every ticket each day, the support team worked long hours to meet demand.  [1]

People often advise only hiring when you absolutely need to hire. There’s some wisdom here - it helps prevent a bloated team and keeps process efficient. But, I think this this is fundamentally incorrect. We’ve created a new framework for hiring:

Plan to hire every position 1 month earlier than needed

Here’s why I like this approach better:
1. The team will be more effective
When people are at capacity, they can’t think of efficiencies and improvements. They can only solve issues on a case by case basis, instead of having the space and time to think holistically. Holistic thinking, not working until exhaustion, is what produces efficiency.

2. People stay at the company longer
Many of the resumes we see have people staying at companies a transient 1-2 years. Many of them were overwhelmed at their previous positions (see Your company should never be frantic). Finding the right people to join your company is a huge effort. Having a consistent group of people solving an important problem over a long period of time is what produces great companies, not a revolving door of burnt out people.

3. Team morale will be better
If a startup is doing well, it will hit capacity often. Startups are built for growth (see Startups = Growth). Growth creates issues, which is why people join startups - it’s fun and challenging. That doesn’t mean you accept all growth issues. It means it’s important to solve as many growth issues in advance that are under your control. That way, the team can more easily handle capacity moments when they come.

4. Customers will be happier
Imagine: you build a product, spend money on growth and when new customers email you -  their first interaction with a person at your company is a negative one. The team doesn’t have time to properly think through a customer question or replies several days later. Phenomenal, expedient support is a startup’s major advantage - an advantage that should never be ceded to competitors. We have an incredible team, but even the most dedicated people can only do so much over long periods of time.

Lastly, it takes a lot longer to find great candidates than you imagine. Even if you want to wait until the very last possible moment to hire someone, it’ll take at least 1 month from the beginning of your search to their start date. Then, it’s important to account for the ramp up period as well.

There’s an image of startups being in a constant state of hitting capacity; since that’s what startups are supposed to be like, it’s not worth problem solving in advance. I think that’s wrong. It’s because startups will often grow fast that you absolutely need to remove as many of the full capacity moments before they happen that are under your control. We still have a lot to learn, but, as one solution, we’re going to start hiring people one month early.



[1] The support team kicks ass, btw. We’ve since made additional hires and we’re still hiring. If you’re interested in joining, feel free to apply:

Collect your naysayers

I remember showing HelloSign to a family member. He barely took a look before getting distracted and walking away. Of all people, you’d imagine that family would be the easiest sell. Yet, working on a company comes with a lot of rejection, whether it’s apathy, passing on an investment, or a user not signing up (The rejection book). I see a lot of founders resent these people. 

I’ve grown to think of rejection differently: I collect my naysayers.  For some reason, I love these people. The bigger the group, the more I’m energized to prove them wrong.

I treat them well, stay in touch and often become friends (Treat investors well when fundraising). Over the years, some of them have even become investors or signed up as HelloSign users. My favorite naysayers are the ones that articulate why they don't believe. They take the time to call or write an email with their feedback. I often learn the most from these people. Then, if we raise, they’re often the first we talk to.