Pre-Seed Valuation Models: Choosing the Right Approach for Your Startup

Among the various stages of funding, pre-seed funding is the earliest in financing for startups. It occurs before the start of a fully developed product or a significant customer base. Friends and family, angel investors, or venture capital (VC) often provide it.

Have you ever thought of how start-up fundraising happens? It all boils down to securing the necessary support and resources to turn a great idea into a successful business. According to a DocSend report, the average amount of pre-seed money raised in the US is ~$500k per round. Globally, the average amount is ~$415k.

Let’s discuss the basics of Pre-seed funding, their valuation models, and how to choose the right model for your Startup.

What is Pre-Seed Funding?

In the beginning, during the pre-seed funding stage, you’re out to convince friends, family, or angel investors that your idea has real potential. This money helps you build your product, do market research, and bring in key team members. As you progress, you might move on to a seed round. Seed funding allows you to refine your product, expand your operations, and reach a bigger audience.

Pre-seed funding It’s not just money; it’s the support that turns ideas into real businesses.

As your startup grows, you will go through multiple funding rounds known as Series A, Series B, Series C, and so on. Each round represents a new level of growth for your company.

Stripe, founded by brothers Patrick and John Collison in 2010, has raised 10 equity funding rounds — pacing at almost one funding per year — from its pre-seed Y-Combinator round in 2010 to its most recent, a $600 million Series H round that valued the company at $95 billion. In total, Stripe has raised $2.2 billion from 39 investors.

What are the Pre-seed Startup Valuation Methods?

Now that you know the factors affecting the valuation, you can choose appropriate valuation methods to determine your company’s worth. Below are some of the common valuation methods used.

Comparable Company Analysis (CCA)

This method involves comparing the startup to similar companies in terms of industry, stage, and size. Investors base the valuation on the financial metrics and valuations of comparable companies. This includes factors like revenue, growth rates, and market share.

Discounted Cash Flow (DCF) Analysis

DCF estimates the present value of a startup’s future cash flows, considering the time value of money. Using a discount rate, investors project future cash flows and discount them back to their current value. This rate reflects the risk associated with the investment.

Berkus Method

This method focuses on assessing specific value milestones. Investors assign values to various elements of the startup, such as the quality of the management team, the prototype or product development stage, strategic relationships, and market potential.

Scorecard Method

This method compares the Startup to key performance indicators (KPIs) and benchmarks. Investors assign scores to various factors, such as the team, market potential, and product, and compare the Startup against industry benchmarks.

Risk Factor Summation Method

This approach considers the level of risk associated with a startup. Investors identify and assign values to various risk factors related to the Startup, and the sum of these values contributes to the overall valuation.

How do you choose the correct Valuation model for your Startup?

Choosing the right way to determine how much your pre-seed startup is worth involves looking at different things. First, consider what kind of business you have, how far along it is, and what’s happening in the industry.

If your Startup has clear costs and is involved in tangible assets rather than ideas, methods like the Cost-to-Duplicate or discounted cash flow (DCF) might work.

If your strengths are in things like having a good team or unique partnerships, methods like the Berkus Method or Scorecard Method, which focus on less tangible stuff, could be better.

You could also check how similar companies are doing with the Market Comparable Method or stick with what’s typical in your industry with stage-based valuation.

If you want to wait to decide on a value, go for convertible notes or SAFEs. The most important thing is to stay open and talk to potential investors to determine what works best for everyone.

Example for Pre-seed Funding for Startup Valuation

Let’s take the example of a pre-seed startup that is developing a new type of AI chip. The startup has a strong management team with experience in the AI industry and is targeting a large and growing market.

The startup believes its unique and innovative product merits a higher valuation than the median pre-money valuation for AI startups, which is $12 million.

To determine the value of a startup, we can use the following approach:

• The median pre-money valuation for AI startups is $12 million.
• To account for the uniqueness and innovation of the products, a 20% adjustment will be added.
• Adjustment for strong management team: +10%

Final valuation = Median valuation * (1 + Adjustment for unique product + Adjustment for management team)Final valuation: $12 million * (1 + 0.20 + 0.10) = $16.8 million

The AI startup has a pre-seed funding valuation of $16.8 million, based on the median pre-money valuation for AI startups, the startup’s unique and innovative product, and the strength of the startup’s management team.

What are the factors influencing Pre-Seed Valuation?

Investors consider various factors to determine the pre-seed funding valuation of a startup when deciding the company’s worth at its early stage. here are some factors that typically influence pre-seed valuation decisions:

1. Founding Team — The founding team’s experience, expertise, and track record play a crucial role. Investors assess the team’s ability to execute the business plan and navigate challenges.
2. Market Opportunity — The size and potential of the target market significantly impact valuation. Investors are interested in startups operating in large, growing markets with untapped opportunities.
3. Product or Service — The stage of product development and the uniqueness of the offering influence valuation. A prototype or minimum viable product (MVP) can provide investors with insights into the startup’s progress.
4. Traction — Early signs of market traction, such as user engagement, customer acquisition, or partnerships, can positively affect valuation. Investors want to see evidence of demand for the product or service.
5. Market Dynamics — Investors want to know how a new business fits into the market and what makes it special. They look at what sets the startup apart and how it can compete effectively. This helps them determine if the startup has unique strengths that can lead to success.
6. Investment Terms — The terms of the investment, including the equity percentage offered in exchange for funding, can influence the valuation. Investors and founders negotiate these terms based on mutual agreement.

What are the Negotiating Strategies for Pre-seed Valuation?

Negotiating the valuation of a pre-seed funding for a startup is important for securing funding. Here are some straightforward negotiation strategies to consider:

• Research and understand comparable valuations in your industry and region. Knowing what similar startups have received can provide a benchmark for your negotiation.
• Understand the stage of your startup and set a realistic valuation. Being overly optimistic may discourage potential investors, while being too conservative may undervalue your business.
• Emphasize any significant achievements or milestones your startup has reached. This could include user acquisition, partnerships, product development, or other key performance indicators that showcase progress.
• Gain insights into what potential investors are looking for in terms of returns and risk mitigation. Tailor your valuation discussion to align with their investment goals and expectations.
• Establishing a good rapport with potential investors is crucial. A positive relationship can lead to more flexible negotiations and better terms. Be transparent, responsive, and open to discussions.
• Be aware of alternative funding sources and keep them in mind during negotiations. Knowing you have other options can give you more leverage in discussions.

Create your company’s Pre-Seed Cap Table on EQVISTA!

In the pre-seed funding stage, founders get a share based on their efforts. External investors trade money for equity. This means that the Equity Distribution process starts from a startup’s Pre-Seed stage. This is done for founders and investors and involves early-stage employees. Hence, creating and managing a cap table will make the equity distribution process easier.

Eqvista’s pre-seed cap table easily allows you to determine details about the ownership of company shares and dilution of the share price over time. To know more, reach us today.