Valuation Method: Running Costs and 20% Margin
Seed investors always invest in people and ideas. Since ideas are fleeting, the most important is the execution. Most of the Venture capital firms invest in people who execute and know how to get the product done and into the market. Seed Investment refers to a series of related investments which 10 or fewer investors “seed” a new venture with anywhere from $50,000 to $2 million. This invested money is often used to support initial market research, plus early product development.
Just a little technical advice:it doesn’t look good if you are raising pre-seed money and have nothing but an idea and a team (pre-seed is usually $200,000 – $500,000). This misconception discourages investors from participating in pre-seed opportunities; it is better if you come up with a concept to get some money from your closest source. Once you have something to demonstrate, such as product, team, and potential clients, it is much better to ask for seed money, even if your company has zero revenue.
For this reason, I came up with a method which might fit your need when you will be asking for any seed investment. It is very simple and logical. The most important part of any startup is to plan your budget for at least 18 months. Your runway may be as long as 18 months and you need to make sure that you will receive an investment covering this period. For example, our new product in Eqvista was completed within 7 months so we have 11 months to find clients and some market share. So it is doable to get your product done within 6-7 months.
Of second importance is the valuation e.g. how big your team should be. If you know that you will need 6 -7 months to launch your product, calculate how many people you need. For example:
Your Team ($540,000 USD):
- 3 Junior IT Developers $ 60,000 USD (per each)
- 2 Senior ID developer $100,000 USD (per each)
- 1 Senior Online marketing developer $80,000
- You as the owner of the company $80,000 (never pay yourself more than the average)
Office running costs (rent, phone, internet, utilities) = $ 108,000 USD
Total Costs: ($540,000+$108,000) x 1.5 years (18 months) = $ 972,000 USD
Depending on valuation methods, you can value your product and idea where they become part of the investment; Berkus Method gives you the opportunity to come up with Sound Idea or Prototype. These 2 elements become part of the valuation.
Scorecard Value Method counts in the Product/Technology and Size of the Opportunity.
In our method, you use the rule of 20% where that would be the margin if you sell your product. Let us presume that a healthy margin is 20%. So if you work on any project or product and you expect to sell it, your added value should be marked up by 20%. This twenty percent is basically the extra value you bring to your project. Again, this is the statement you are able to rationalize if any investor would question why 20%. We might look at this 20% as expected profit. However, 20% represents the Sound Idea (basic value, product risk), Prototype (reduces technology risk) in Berkus Method or Product/Technology, Size of Opportunity in Scorecard Valuation Method. These 2 models are quite subjective. I believe that this will help you to get your feet on the ground once you get challenged by any investor.
Total (with your 20% margin) = $ 972,000 USD x 1.2 = $ 1,166,400 USD
I am convinced that this is a sound approach, and you can always uphold the reason why your valuation is set as it is. As stated above, It has a reason.
Now the question is how much equity you should give up.
For a $1M seed round:
A VC firm will look to get 10%-20%
A group of angels/seed will look to get 15-25%.
However, I really like the other valuation methods (Berkus Methods, Scorecard Valuation Method), but, I feel that it would be very difficult to defend the numbers if you are asked why you think that your idea is worth $500,000. It is much better to be able to demonstrate how much money you need to build up a team and cover running costs. The 20% margin is also a great way to explain that this is the profit you would expect if you sell that project after 18 months. A 20% margin is a healthy markup for you in exchange for your experience and your knowledge.