Demystifying startup valuation: a simple formula for pre-seed and seed rounds

Ashot Arzumanyan

Dec 17, 2024

4 min read

Valuing an early-stage startup doesn't have to be a complex puzzle. For many entrepreneurs, determining how much their company is worth feels daunting, especially with little to no revenue. The good news is that there's a straightforward formula that can guide you through pre-seed and seed valuations. In this article, we'll break down this simple valuation method, explore the key factors that influence it, and show you how to effectively plan your funding rounds to fuel your startup's growth.

Understanding value vs. price vs. VC economics in startup valuation

First, let's differentiate three critical components of startup valuation:

Value: This is the present value of future cash flows for shareholders. Factors driving value include your team's ability to execute, traction as proof of potential, a big or growing market, a solid go-to-market plan, intellectual property differentiation, and more.
Price: A function of supply and demand, price has only an indirect link to underlying value. If capital is scarce or there are many decent investment opportunities, the price may decrease regardless of value, and vice versa.
VC Economics: Often overlooked, this factor is driven by the venture capital rule: "Only invest in companies that have the potential to return the value of the entire fund" (as Peter Thiel famously stated). For example, a VC with a $100 million fund seeks startups that could potentially return at least $100 million upon exit. Even if the price suggests a decent return, if it doesn't allow the VC to potentially recoup the entire fund, it may not align with their investment strategy.

In short, price is what investors pay; value is what they get. The same startup can have a very different price (or valuation cap) depending on investors' willingness to deploy capital. Remember the blockbuster rounds, IPOs, and valuations of 2021 compared to today. Dry powder - the capital VCs have raised but not yet deployed - reached record highs in 2023. However, high interest rates and uncertain stock market performance are holding investors back, leading to more conservative valuations.

Valuation is always driven by story

A startup is a story about future growth. Aswath Damodaran, a founding father of corporate valuation theory, defines three main attributes of a story: possible, plausible, and probable. In the early stages, you can often get by with a story that is merely possible - hypothetically feasible but not yet supported by strong evidence. As your startup progresses, the story needs to become increasingly plausible and probable, with proof points validating its likelihood of success.

Storytelling in valuation isn't about fantasizing. The team behind the story makes a huge difference. A serial entrepreneur telling a compelling story of disrupting yet another industry will attract significantly more funding than a newcomer who will need to show a lot of numbers before being trusted with serious money. Furthermore, a Stanford student might get more than a student from a regular college, as investors may assume access to powerful networks of mentors and talent.

Take Airbnb. In its early days, the founders didn't just pitch the idea of renting out spare rooms; they introduced a revolutionary business model centered around the sharing economy with immense scalability potential. Even though this concept defied conventional logic at the time, their story was possible and plausible. Their ability to articulate this vision effectively attracted investors who believed in disrupting the hospitality industry through a scalable, user-driven platform.

Minimum viable milestones

Conversations with investors often focus on the Minimum Viable Product (MVP), which makes perfect sense. However, you should also think about minimum viable milestones and plan them so that, if achieved, they will enable you to raise a larger round at a higher valuation within 9–18 months.

Minimum viable milestones are the key achievements your startup needs to validate its story and justify a higher valuation for the next funding round. These could include:

Reaching a certain level of monthly recurring revenue
Acquiring a specific number of paying customers
Establishing partnerships with key industry players
Demonstrating product-market fit through high user engagement and retention.

Adopt a bottom-up approach when planning your capital needs. Instead of starting with a predetermined amount and deciding how to spend it, first identify your key objectives and milestones. A startup isn't merely a cost center; it's a value-creation machine. By clearly defining your goals, you can work backward to determine the funding required to reach them. This bottom-up milestone planning ensures that every dollar raised is directly tied to strategic objectives and measurable outcomes. It shifts the focus from spending money to creating value, aligning your startup's capital strategy with its overall mission and growth trajectory.

The simple formula for startup valuation in pre-seed and seed rounds

For early-stage startups with little to no revenue, valuation is often a function of the round size. Here's a simple formula:

Pre-Seed: Valuation = Round Size / 0.1
Seed: Valuation = Round Size / 0.25

Generally speaking, the bigger the round size, the higher the valuation. However, the round size itself should be determined by the amount of capital your startup can reasonably absorb and deploy to achieve its minimum viable milestones.

Examples:

Pre-Seed Example: If you're raising a pre-seed round of $500,000, using the formula Valuation = Round Size / 0.1, your startup's valuation would be $5 million.
Seed Example: For a seed round of $2 million, applying the formula Valuation = Round Size / 0.25 results in a valuation of $8 million.

How to assess your startup's capacity to absorb capital

Your startup's capacity to absorb capital is closely tied to your team's ability to execute on your plan and reach your milestones. Consider two cases:

Team A seeks to raise $3M to onboard an experienced sales and growth advisor as a full-time team member. This new sales lead, with a proven track record, will enhance their go-to-market strategy.
Team B also wants to raise $3M but plans to hire a "magician" salesperson to execute a "great" and "unique" sales and marketing plan.

All else being equal, Team A has a better capacity to absorb $3M because they have a clearer plan for deploying the capital effectively, they proved they can acquire high-caliber talent. Team B might be advised to raise a smaller round (say, $1M) to refine their strategy and build a stronger foundation before seeking a larger investment. If capital is the fuel, you can only take as much fuel as your capacity allows.

Other factors can impact valuation (a subject to a whole other article), such as market conditions and investor sentiment. When capital is abundant, VCs may encourage startups to spend more, expand aggressively, and raise larger rounds. Conversely, during a downturn, VCs may advise startups to be more conservative with spending and raise smaller rounds. Understanding investor motivations and constraints can help you navigate valuation discussions more effectively.

In conclusion: it's not just about money

Unsophisticated investors may jump on any deal at any valuation. All an entrepreneur needs to close them is good salesmanship. However, if as an entrepreneur you are the smartest person in the room, you're in trouble, especially at early stages. You want smart people with vested interests beside you, working hard to make sure the story you tell becomes reality. Often, it makes more sense to side with investors who are committed to your story rather than those who simply write a big check with unreasonable terms.

Finally, thinking big is important, but it makes sense not to oversell. You might sell a nice story, but if your milestones aren't achieved, facing a down round can challenge the team's morale. Think big, but grow steadily, focusing on building a strong foundation for your startup's valuation in the pre-seed and seed stages and beyond.

Further reading

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