The following is an edit of a post originally included as part of a discussion on the Funding Game group on LinkedIn. The full discussion can be found here: lnkd.in/8KTfYZ
When it comes to investing in early stage, pre-revenue companies you simply don’t assign them a valuation.
There are equity-like / hybrid instruments you can use to provide early stage funding that do not imply a valuation for the start-up.
What a seed / pre-seed investor will be backing is pure potential.
Sure, there are ways to measure the potential, and also to risk-weight the chance of the full potential being achieved. However, these are clearly not scientific. In fact, they are almost entirely ‘finger in the air’ in their methodology.
The question you need to ask is why complicate funding matters by arguing over valuation?
Instead, address the core funding issue – how much funding does the company need in order to get to a revenue (or, more importantly, profit) generating stage? Then add extra ‘runway’ in case of an aborted take-off.
Convertible debt is the simplest way I can think of investing in this fashion.
The only valuation point that really needs to be addressed here is the discount the holders of the convert can expect when the company reaches a stage where establishing a valuation makes sense, and equity in the company is sold. NB – at this point, convert holders have the option (or possibly are obliged) to ‘convert’ their debt into equity.
I recognise that there are those who feel that converts potentially limit returns to the debt holders (e.g. http://www.matr.net/article-29148.html).
However, practically speaking, I think that the downsides are limited, and that they can broadly be addressed by baking in a suitably high discount into the convert.
So, I guess that my answer is simply: Avoid the valuation debate at pre-revenue stage in the first place!
I am in the process of putting my money where my mouth is, so to speak, by structuring my seed investment into a pre-revenue tech startup broadly as described above.
More details to come as we get further down the line in our discussions.
Perhaps my views will change as the negotiations progress, but as things stand the approach outlined above appears to be the most sensible for all parties at the seed funding stage.