Startups often have no revenue and sometimes even no working product at a pre-seed or seed stage fundraising. Therefore, investors can’t apply revenue multiples - a typical valuation approach for series A/B/C funding rounds.
From the VC investors’ perspective, the return on investment is what eventually matters the most. Typically, early-stage investors would have a target return (based on their portfolio strategy) that could range from 10x to 100x per investment.
The entry valuation is then driven by the expected/possible exit valuation. For example, entering a seed stage startup at a $10m valuation makes sense for an investor with a 50x+ target return for as long as there is a visible path for the startup to become a unicorn, resulting in 50x-70x return for the investor (post further fundraising dilutions). The challenge is obviously to estimate the probability of a certain valuation on exit which is more of an art than science.
In the absence of enough data to build a proper valuation model, VCs look at founder/team experience, total addressable market (TAM), product quality, early traction data, competition, other investors joining a round etc. Having analyzed hundreds of deals, early-stage VC investors have a good feeling about where the market for a startup valuation is (given the factors above) and take it into account along with the target return approach outlined above.
From the startup founders’ perspective, the valuation decision for a seed stage round is often driven by the capital required vs acceptable dilution which is typically in a 5-20% range. For example, assuming a startup needs $1m seed money and founders are ready for the 10% dilution, the implied acceptable post-money valuation for the founders would be $10m.
