When you begin seed fundraising, it’s often very difficult to know what price you should set for your “valuation cap” on a SAFE or convertible note. I often suggest founders start with a low valuation cap and then increase it over time, based on demand. Here’s how the approach works:
Even when you’re just beginning your fundraise, you can create scarcity and push investors to a quick decision:
- Start with a slightly lower valuation than the current market standard, I usually advise a $3–6M valuation cap range, with the top end for startups raising in Silicon Valley (this would be for a seed stage company at ~$100k ARR, with ~15% month/growth).
- Make sure your early meetings involve Angel investors and other small check writers ($10-$100k). Show them a use-of-funds plan to spend $250–500k over the next 6–9 months, reach your next milestone and then go out to complete your full seed round raise of $1–3M.
- The low valuation and limited round availability will entice smaller investors to give you a quicker “yes”. Once you’ve hit the (very low) target of $250–500k, your round is oversubscribed. You might find yourself telling potential investors: “We’ve been surprised by the demand”.
Build your Ladder
Once you’ve hit your initial target, you’ll want to increase the valuation cap, reducing your dilution as you take on additional capital. There’s a few ways to do this:
- My recommendation: increase the valuation cap in $2M increments. After you’ve raised your first $250k. You increase your valuation cap by $2M, so it would now be $5–8M. I then recommend you restrict the amount of investment available to $500k in each increment, going up to a $12M cap maximum, to avoid high valuation problems in the next round.
- If you don’t need much more capital than your initial target for the round, you can double your initial valuation cap, so your cap would now be $6–12M. Although aggressive and unadvisable for most, it’s a good way of quickly filtering your investor list to an immediate “yes” or “no”, if you have numerous leads and want to close ASAP, regardless of the final amount.
- You may also increase the valuation by a smaller amount, but do it multiple times to create further scarcity. For example: if you increase the valuation cap by 50%, so your cap would go from $3–6M to $4.5M-$9M, you could set a max of $500k to be raised at that valuation. Then, once that additional $500k is raised, you might increase the cap by another 50% from $4.5M-$9M to ~$7–14M.
Despite understanding “supply and demand”, plenty of investors will not be happy about paying a higher price than someone else who invested very recently. When they push back, you can respond with the following reasoning:
- Blame a third party, such as a promise to your team or other investors. For example, “I promised the team they wouldn’t take more than 20% dilution this round” or “My largest investor is pushing me to only take 20% dilution” .
- Demonstrate to the investor that increasing the valuation is reasonable because your company is now a less risky investment, with significant cash on hand. You can say “With our current bank balance, we have up to a year of runway and that’s a significant de-risking of your investment; hence the higher price”.
- To stop yourself from caving to investor pressure on a price increase, you can use a SAFE with a post-money valuation cap. Then you won’t want to take more money at the current post-money valuation cap, because the new investment reduces your “pre-money” valuation.
$1M raised on a $6M post-money cap is equal to $1M raised on a $5M pre-money cap.
However, if you then raise $500k more at the same valuation cap, things change -
$1.5M raised on a $5M pre-money cap is equal to a $6.5M post-money cap but $1.5M raised on a $6M post-money cap is equal to a $4.5M pre-money cap.
Thus, when using a post-money cap SAFE your pre-money valuation cap would drop by $500k or 10%, because of the additional funding.
Few founders can realistically be expected to guess the correct valuation for their startup’s seed round. Starting low and increasing your cap, based on demand, removes the guesswork and increases your chances of a good outcome.
This article is part of a series on Seed Fundraising.
1. When to Raise Money
2. How to Build a Deck
3. VCs vs. Seed Funds vs. Angels
4. How to Get a Meeting
5. How to Request an Introduction
6. How to Get Early Momentum
7. How to make a Good Pitch Great
8. The 5 Most Common Pitch Mistakes
9. Meeting Requirements
10. The Basics of Meetings
11. How to Handle an Angel Investor Meeting
12. Know these Numbers for your VC Meeting
13. 4 Investor Gotcha Questions
14. How to Follow-Up After an Investor Meeting
15. How to Close the Lead Investor
16. The 4 Stages of a VC Process
17. How to Raise a $2 Million Seed Round
18. Go from Investor YES to Cash in Hand
19. When Investors Say Yes but Mean No
20. When and When Not to Use an Investors Name
21. Stop Making These Common Fundraising Mistakes
22. How to Avoid Bad Terms that Kill Startups
23. What to do After Receiving a Term Sheet
24. Term Sheet Problems Part 1 — Money Talks
25. Term Sheet Problems Part 2 — Boardroom Blues
26. Term Sheet Problems Part 3 — Side Letters
27. 10 Traits of Successful Founders