How do you calculate and determine what a fair valuation cap is?
This post originally appeared on Gil Silberman’s Quora.
A fair valuation cap is whatever the market will bear. So look to the market for comps.
There are plenty of good explainers for what a valuation cap is and does, so I won’t get into that. Just keep in mind that it’s only one of several key terms negotiated between startup companies and their investors by which the investor purchases a security instrument (a convertible note or a SAFE) issued and sold by the company to raise money. The valuation cap is a dollar figure that relates most closely to the perceived value of the company, but only indirectly.
A fair number would be one that a willing investor would accept from a willing company, assuming on both parts a degree of sophistication, rationality, access to information, and bargaining position that all lie within normal bounds.
Where to look
If that is you, how can you figure out what is normal to ask for or bid, so as not to undersell yourself on the one hand, or project greed and cluelessness on the other, either of which is a red flag that could kill the deal?
The answer is to find examples if you can, do some online research, and ask your trusted advisors – mentors, cofounders, colleagues who founded other businesses, accountants, lawyers, friendly investors, and so on. There are discussions online, for example on Hacker News, Quora, and Stack Exchange.
At any given time nearly all valuation caps will fall within a range of 1.5 to 2X for any category of company based on its stage (brand new, pre-seed, seed, etc.), product cycle (in development, MVP, launched, validated), revenues and revenue growth if any, geography (the nation and region where the company and its customers are physically located), genre (marketplace, B-to-C, SaaS, embedded tool), and industry sector (hospitality, construction, capital markets, agriculture, transportation, etc.). If you can fit your company into one of these buckets, or triangulate from adjacent ones giving extra weight to the more recent and relevant examples, you’ll find the range.
For example, you may find that typical valuation caps this year for pre launch embedded insurance tech companies run by New York based first time founders serving the construction industry are in the $3 to $5 million range, via a post-money SAFE with no discount or MFN.
Companies negotiate with lead investors
Usually, a company either sets the valuation cap and other terms and runs with it to see if investors accept, or else it finds a first key investor to negotiate a number. The terms then remain constant for all investors (other than the occasional side letter) from the first closing through the entire round unless there is a significant change in circumstance or a later key investor demands better terms. Occasionally a key investor will make the first offer, but it’s usually the company.
As a negotiating strategy you can start at the favorable end of the range, and trade the number for other possible concessions as negotiations progress. In the above example the range is $3 to $5 million, so a company might as well ask for $5 million.
Where the negotiation lands depends on a combination of founder presentation, credentials, experience, competing offers or negotiating leverage, the company’s fundraising history, and to a lesser extent, negotiating savvy. A desperate company with no other offers will have to take whatever the lead investor may offer, or else bluff or do without. A company that’s doing well and oversubscribed can name its own terms, but ought to be cautious and choose investor quality over the best offer – because setting too high a price may drive away backers who are the most sophisticated and therefore helpful in the future. Raising money on too good of terms makes it more likely that the next round will be a down round, which creates problems of its own.
How not to do it
Contrary to some opinions, setting company valuations is not based on cash flows, expected future values, or any financial calculations or appraisals of the company or its assets. Not for seed and pre-seed stage companies, anyway. You can make those calculations if you wish, and it’s a good exercise to help you understand startup economics. But they aren’t part of the negotiation logic. If you’re an investor and don’t like the answer you shouldn’t be investing in convertible notes or SAFEs. If you’re a founder and you don’t like the answer, tough luck because you probably need money and those are the terms you will get when you raise it.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.