In the world of technology startups in the pre-seed or seed stage, the search for a logical valuation becomes, for many entrepreneurs, an enigma since their companies do not meet any of the premises on which valuation methods are based in established financial conventions.

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Therefore, instead, they must explore approaches that are more appropriate and sensitive to the unique and volatile nature of this entrepreneurial ecosystem. Evaluating a startup in its initial stage requires a completely different approach, one more based on a deep understanding of its disruptive potential, the quality of its founding team and its target market. Among the methods most used by VCs we can mention:

• Comparable based assessment (Comparables Method): Despite its limitations, investors often use this approach as a reference point. They compare the startup in question with other similar ones that have received investment in recent rounds. This provides an idea of how it is valued relative to its peers in the market.
• Rating based on key metrics (Traction Metrics): VCs often pay close attention to a startup's key operational metrics, such as user growth, customer retention, monthly recurring revenue (MRR) and other traction indicators. The stronger these numbers are, the higher the company's potential valuation will be.
• Assessment using the equipment and vision method (Team and Vision): Investors also evaluate the founding team and its vision for the business. A team with experience and ability to execute the startup's vision can significantly increase its valuation.
• Assessment by funding needs (Bargain Method): Some investors consider how much capital the startup needs to achieve its key milestones and achieve a higher valuation milestone. If the startup only needs a small investment to reach a significant tipping point, this can influence a higher valuation.
• Evaluation by market and potential (Market Potential Method): VCs also evaluate the size and potential of the market the startup is targeting. If the company is tackling a large and growing market with a unique approach, this can increase its valuation.

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As can be inferred, all these methods are very approximate and not a single one will suffice, but it will be necessary to reach a conclusion by averaging a few of them. And yet, due to the lack of scientific rigor, the result will tend to divide the opinions of entrepreneurs and investors...

• “Founders are often competitive people, and since the valuation is often the only visible number associated with a startup, they end up competing to raise money at the highest valuation. This is absurd, because raising funds is not the test that matters. The real test is income. Fundraising is simply a means to that end. Being proud of how well you did in fundraising is like being proud of your college grades,” says Paul Graham, one of the four founders of YCombinator.
• “The average Exit value of a European technology startup is 38 M€, if we aim for a reasonable multiplier at the fund level, we cannot enter valuations higher than 4.0 M€” I heard more than one General Partner of European VCs say.

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From this we can deduce that 4.0 M€ can constitute a barrier that is difficult for many VCs to overcome, unless the startup they are talking to is very unusual. This is a fact that I recommend entrepreneurs to reflect on. And if this has not convinced you, I invite you to continue reading the reflections of Paul Graham, who knows a lot about all this:

“The empirical evidence shows how unimportant (the valuation of startups) is. Dropbox and Airbnb are the most successful companies we've funded so far, raising money after YCombinator at previous valuations of $4 million and $2.6 million, respectively. Prices are much higher now, so if you can raise money, you'll probably do it at higher valuations than Dropbox and Airbnb. So let that satisfy your competitive spirit. You're doing better than Dropbox and Airbnb! It's a test that doesn't matter.”

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Graham is a plain person, who expresses himself categorically, in terms of black or white, that is why and because what he says is based on concrete experiences with some of the most successful startups on the global entrepreneurial scene, his final reflections and recommendations about the valuation of startups and other key elements of a round, are extremely valuable. So much so, my recommendation to entrepreneurs to read their full article on the YCombinator website, because really, it's not wasted. For the sake of not losing completeness, I will summarize the most significant sentences, but again, I recommend that you read the original article:

“If you're raising money from multiple investors, as most startups do, you should be careful to avoid raising the first one from an overzealous investor at a price you won't be able to afford.”

“If you have 'enthusiastic investors' as your first investors, it is advisable to raise money from them through an unlimited convertible note with an MFN (Most Favored Nation) clause.”

“While it's a mistake for investors to worry about the price, a significant number do.”

“If a first-time investor asks you about valuation, “tell them that valuation isn't the most important thing for you and that you haven't thought much about it, that you're looking for investors that you want to partner with and who want to partner with you, and that they should first talk about whether they want to invest at all.”

“Sometimes, you'll encounter investors who describe themselves as 'valuation sensitive'. What this means in practice is that they are compulsive negotiators who will absorb a lot of your time trying to lower the price. Therefore, you should never approach these types of investors first.”

“There are a handful of investors who will try to invest at a lower valuation even when your price has already been set. Lowering your price is a 'backup plan' that you turn to when you discover that you've let the price be set too high to raise all the money you need.”

“If someone makes you an acceptable offer, accept it. If you have multiple incompatible offers, choose the best one. Don't reject an acceptable offer in the hope of getting a better one in the future.”

“Sometimes, low-tier investors make offers with very short terms, because they believe that no one with other options would choose them. A deadline of three business days is acceptable. You shouldn't need more time if you've been talking to investors in parallel. However, an even shorter time frame is a sign that you're dealing with an unreliable investor. You can usually test their sincerity and you may need to.”

“Our general rule is not to sell more than 25% in a Seed round (prior to Round A), in addition to what you sold in the pre-SEED round, which should be less than 15%. If you're raising money with non-CAP notes, you'll have to guess what the possible valuation might be in the stock round. Make a conservative estimate.”

“If you have several founders, choose one to be responsible for raising funds, so that the others can continue working in the company. And since the danger of raising funds isn't how long the meetings themselves take, but rather that it becomes the main idea in your mind, the founder who is in charge of raising funds must make a conscious effort to protect the other founders from the details of the process.”

“The founder who is responsible for raising funds must be the CEO, who in turn must be the most prominent founder.”

“It's a mistake to behave arrogantly toward investors. Although there are certain situations in which certain investors may appreciate a certain type of arrogance, investors vary widely in this regard, and a gesture of superiority that might subject one to one can make another one indignant. The only safe strategy is to never appear arrogant at all.”

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I hope that these reflections of one of the most important investors in the global ecosystem will help you to guide you in this diffuse and unscientific matter such as the valuation of startups. If you have a technology startup and are looking for investors, we are interested in getting to know you. Write to us at dealflow@intelectium.com.

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If you want to learn more about the recommended methodologies for evaluating startups, here is another article from our CEO that may interest you

👉 https://www.intelectium.com/post/valoracion-startup