The Five Pillars of Seed Stage Fundraising.

There are five attributes that investors commonly use to value early stage companies where the valuations range from $0-5M.  In this post, we explore these five attributes in detail: market, team, product, distribute, and traction.

Early stage startups are hard to value.  This is fundamentally due to a combination of the high failure rates within startups and the uncertainty inherent  in the  discrimination  process.  In other words, its not just that around 90% of startups fail, its that there is very little signal to indicate which startups are likely to fail and which are likely to succeed.

Because of this high failure rate and lack of certainty, we see big swings in startup valuations.

At one end there are accelerators like Y Combinator who, on average, value companies at around $1.5M before entering the program.  On the other end, there are companies like Clinkle who have raised tens of millions of dollars before even launching a product.

Even with these wide fluctuations, there are some guidelines that can be used for valuing the majority of new startups.  One method commonly used by investors (sometimes unknowingly) is to evaluate a company against the following five attributes:

• Market – The direction of size and growth of a particular market segment.
• Team – The collection of skill sets and the cohesion within a founding team.
• Product – The demonstration of a team’s ability to execute on a product.
• Distribution – The ability to get a product into an end user’s hands.
• Traction – The measurements indicating growth in product adoption.

As a crude generalization, each of these five attributes represents $1M in valuation meaning that a startup that is exceptional in that attribute can credibly add $1M to its pre-money valuation.  There are reasons for this $5M cap which has to do with a common strategy that investors use when managing a seed fund, but we’ll talk more about that in future posts.  For now, to get a better sense of how to think of these attributes, consider the following explanation for each:

Market

A good way  to understand how investors look at a market opportunity is through a surfing analogy. If you ask a surfer what their favorite moment was while surfing, it likely had to do with riding a big wave.  A surfer knows that it doesn’t matter how hard you paddle, if the wave isn’t huge, the ride isn’t going to be anything to brag about.  Similarly, investors aim to find opportunities happening in a market that has the potential to be massive.  Execution is still critical, and if a surfer doesn’t time the wave right, or doesn’t have the board control skills, they will likely miss the wave or crash altogether.

One of the many challenges in evaluating the potential of a market is that in many cases, a startup is going after a market that does not yet exist.  So how do investors know when there is a big market opportunity?  This is where “vision” fits in.  A key trait for an entrepreneur is the ability to see a vision of the future before it happens.  The better an  entrepreneur can understand and clearly communicate the dynamics of a nascent but fast growing market, the greater the potential valuation of their company.

As an example, consider the “sharing economy”.  Less than a decade ago, this market was nonexistent.  It wasn’t until the late 2000s that a handful of startups like Airbnb and Uber saw this wave happening and pioneered the space.  With Uber just recently raising on a $40B valuation within five years of its founding, this wave is now at a high peak and many new entrants are piling in.  All things else being equal, startups in this space are in a great fundraising position.  When investing, just like when surfing, being in the right wave at the right time can be everything.

Team

There are some startups that catch headlines with the amount of money they raise before having any meaningful product.  Often times, it is the track record of the founder(s) that led to the massive investment.  There are extreme examples of this like the now infamous Color, but more generally, a startup team is measured on three dimensions:

• Well Roundedness – Often, co-founders get together because they came from the same background, they share the same friends, they have the same skills.  While cohesion is important (see below), the degree to which a team has complementary skills can define the success of a startup.  A team consisting of a brilliant engineer, a UX designer and a product/sales lead will be more more attractive than three MBAs or three engineers getting together to start a business.
• Track Record – The credibility of each individual team member can de-risk a venture.  Often, one of the founders shines here.  A founder who graduated at a top Computer Science school doesn’t guarantee that he/she is the brightest engineer, but it is a signal of an ability to use technology to solve seemingly impossible problems.  Similarly, a founder who has raised venture capital previously is no guarantee of future success, but having gone through that experience before, he/she is less likely to make the same mistakes twice.
• Cohesion – There are two reason that startups fail, either they run out of money or succumb to founder disputes.  While there are many factors that influence the cash flow risk, the degree to which a team has strong cohesion will mitigate the potential for “cofounder fallout”.  Startups are stressful, and stress can bring out character mismatches that a team might not have known beforehand.  What is interesting to an investor is not just how long the team has known each other, but also the depths of challenging moments that they have been through together.  The deeper the stressful past that the team survived, the stronger the bond.

Product

The product that a team produces is seen as a demonstration of the team’s ability to execute.  Whereas the makeup of the team shows potential, the product shows results.  Even if a product does not yet have traction, the polish, usability and performance of the product are indicators of the team’s capability of producing something of value. Product execution influences valuation even in the absence of traction because investors realize the initial product that a startup launches will almost certainly change.

Every product launch, no matter how compelling to a small group of beta testers, will require some modification to reach product/market fit.  Often times, this exercise leads to a “pivot” or a realization that an entirely new product is necessary.  It may be that “mobile-first” does not apply to your industry, or that the real target user of your product is the vendor, not the customer.  The only way to discover this is to launch a product that can begin to answer key assumptions about the business and then iterate.

Savvy investors will expect that their invested capital will be heavily used toward creating a modified or even new product than the original product they invested in.  The better/faster the product execution, the more likely that the next version will resonate with the market.

Distribution

Probably one of the most overlooked risks of an early stage startup is distribution.  Many founders have a “build it and they will come” mentality.  Unfortunately, this seldom applies, and the startup is left with a beautiful product but no users.

If you are building a consumer product, have you successfully gotten an app into the top 10 on iTunes in the past?  If you are a SaaS business, does your team have direct connections with the VP Sales at the top 50 companies you are targeting?

The degree to which you can demonstrate your ability to get your product into your end customer’s hands will greatly predict your success and de-risk a venture opportunity to an investor.

Traction

At the end of the day, traction trumps everything else.  Traction is really the culmination of the first four attributes, and as a startup matures, it becomes the primary source for measuring the value of the company.  However, in the early stages of a startup, its more of a signal that things are coming together.

Most startups looking to raise seed funding do not have detailed metrics on traction, which is why investors use the first four attributes with subjective measurements.  Nonetheless, the more a startup can show on key metrics (revenue, user growth, engagement, etc.) the less risky the company is in the mind of an investor.

The above is an overview of the five key attributes that investors look for when valuing an early stage startup.  We’ve found that most investors will value a startup on a scale of $0-5M using these attributes.  In future posts, we’ll look more closely at case studies where startups have demonstrated each of the five attributes and how impacted their subsequent valuations.