In early-stage investing, especially pre-product or pre-revenue, we often run into the issue of how to properly value a company when raising money from investors. While most startups at this stage are using convertible notes or SAFEs for their first investment round (after friends and family), it's still important to know what ballpark you want to be in when setting valuation caps and considering future funding rounds.
When undertaking this exercise, entrepreneurs tend to use a "bottom-up" approach, which is to say they base their valuation off assumptions of future revenue and growth. What I'll lay out below is a method that uses equity allocation as a metric to "gut-check" and guide your valuation setting (which can later be backed up with revenue calculations or other growth assumptions).
Based on what I've seen in talking with other investors and the startups we've worked with in the past, a good rule of thumb for equity at each stage is as follows:
Friends & Family (typically $100K or less): 1-3%
Seed ($100K+ to $1-2MM): 12-15%
Series A ($1-2MM to $5MM): 25-30%
A few things to keep in mind:
- Even when raising on a note or a SAFE in the early rounds, you should use the valuation cap to dictate the overall equity distribution at conversion.
- At the start-of-life of a new company, having 100% equity makes it feel like there's plenty to go around. Use the above as a way to guide your approach, especially because you have to consider the option pool for early employees, as well as any stock grants you might want to make to contractors to defray development costs.
- Don't forget about dilution. While these numbers may seem like a lot for initial investments, everyone ends up diluted as new rounds of funding come in.
I'm a huge believer in investment roadmap planning in the same way that entrepreneurs conduct rigorous product roadmap planning. The primary purpose of an investment roadmap is to (as accurately as possible) estimate the outside capital needs of the business, the timing for those investments and some rough calculations on valuation at each stage. In undertaking such an exercise, entrepreneurs can engage in a realistic assessment of valuation development for the company, rather than just hoping for a higher valuation than the last round.
There's also a helpful overview on some of the fundamentals of investment and equity allocations that you can find here.