A Bubble for Seed Stage Valuation

January 19 2012 one Commented

When entrepreneurs raise equity capital for startup companies, the investors’ percentage of ownership is determined by the negotiated valuation for the company at the time of investment.  For example, if the negotiated pre-money valuation is $1.5 million and the investors provide $500,000 in equity investment, the investors are purchasing 25% of the company [$0.5 million ÷ ($1.5 million + $0.5 million)].  And, as you might expect, when the company grows and meets important milestones (granted patent, first revenues, etc.), the valuation of the company increases.  If investors fund the company at a later stage, after the company has met important milestones, the investors’ $0.5 million in capital will purchase less of the company.  Not surprisingly, entrepreneurs are generally encouraged to postpone fundraising until critical milestones have been met, so entrepreneurs can sell less of their company to raise a given amount of capital.

But, as Mark Suster points out, the valuation of startup ventures also varies with demand.  When asked if we are now in another demand bubble, Mark responds “Duh…of course….!”  So, not only does valuation increase as companies mature, the valuation of new enterprises vary with a demand cycle.  Demand was extremely high during the Internet bubble (ending in 2001) and very low in 2007-09.  And, in 2012, prices have risen dramatically again.  Will this bubble end soon?  Suster suggests we will see the valuation bubble burst within the next 24 months.

So, valuation varies with demand and with the maturity of the company. 

But entrepreneurs must also realize that there is very little valuation consistency across the geographic and business vertical spectrum of this country.  Some geographic markets are hot (high demand for startup deals in NYC) while others are not (pricing in Montana is much lower).  Some business sectors are hot (Internet) while others are cooling (medical devices).   Entrepreneurs must research startup valuations in both the local market and their business vertical before negotiating for funding.  Also look at several valuation methodologies prior to seeking capital.

What is the message regarding startup valuation?  Entrepreneurs:  Know your marketplace.  Do not expect the same valuation for a gaming startup in Atlanta as for a biotech startup in Boston.    

Here are some important points for entrepreneurs to remember when raising seed/startup capital:

  • Raise money far in advance of need.  It always takes longer to raise money than one expects.
  • Don’t try to predict the fundraising cycle.  You will probably be wrong anyway.
  • Hit as many milestones as possible before raising money, to maintain as much ownership in your company as possible.
  • On the other hand, if investors come knocking at a reasonable valuation and you will eventually need to raise funds – take the money!  A bird in the hand…you know the rest.
  • And, if you are oversubscribed (investors offering more money than you had intended to raise) – take the money!  You never know when a hiccup will result in your new enterprise needing more money than expected.

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