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:

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.

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.


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One Response to Valuing Pre-Revenue Startups

  1. I agree that valuation of a pre-revenue start-up has challenges – but here’s a few thoughts…

    The valuation of any company has challenges e.g. historical figures and trends are no guarantee of future revenues, particularly in tech companies and/or the longer term – additionally the revenue/profit multiplier used during valuation processes are essentially a best guess of future earning potential of the company and the value of the markets it operates in.

    The SEIS and EIS have significant tax incentives associated, not just the income tax relief on the initial investment but also for the future, both on losses, via additional income tax relief, and on gains, via capital gains tax relief. These are pretty significant reliefs and should be borne in mind in valuing a start-up.

    Traditional investment valuation says I’m happy to give you £Xm or pro rata thereof because I believe the company’s value will be more than that in the future; but an EIS/SEIS investment (assuming the income tax relief can be realised in full) is a range of values; firstly 50% relief from SEIS reduces the investment risk and thus to a degree the initial valuation; then the CGT relief on the sale makes for an additional effective increase in the future value by the equivalent tax you would otherwise have paid.

    Take a pre-revenue start-up with a headline post-money valuation of £2m. If an investor puts in £50k in return for 2.5% equity and gets the SEIS relief their effective cash investment is £25k. If the company sells 3 years later for £22m, their share is worth £550k; with the CGT relief that makes the effective sales valuation £32.5m (2.5%=814k-50k=764k-(764k/0.28)=550k). So the effective valuation range is £1m-£3m. The upside figure is the best case, but still…

    A convertible note is in a sense a form of valuation, it’s just a hidden one – one wouldn’t issue a convertible note of value X to a start-up without believing that (a) the company will in the future raise capital of an amount considerably greater than X and (b) that the company’s long term value will be such that your converted note will make your investment worthwhile.

    So while a convertible note is a hazy, broad range sort of a valuation, the SEIS and EIS reliefs make an equity investment similarly hazy and broad range.

    Disclaimer: I’m not a financial adviser, accountant, lawyer, or mathematician, just a co-founder of a start-up currently raising seed investment ;)

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