Challenges of valuing pre-revenue startups

Funding is always an inevitable part of any startup. But how do you find a good investor, and what do the investors expect from your business??

Like Marty Whitman says, “As a value investor, what you are interested in is whether the company is creating wealth.” – It all focuses on your company's value.?

Valuing a startup is more important when it comes to fundraising, but valuation becomes a difficult task for pre-revenue startups. Valuing a startup that hasn't generated any revenue yet is kind of like guessing the weather six months down the line. The process is much more about piecing together various factors like the market, idea, and even the entrepreneur's vision – with its challenge altogether.?

Now, what is a Pre-revenue startup valuation?

Pre-revenue valuation measures the approximate value of the company’s worth. This valuation depends on factors such as market potential, team, product, and funding environment. Pre-revenue valuation plays an important step in growing the business and let us understand how.

As Pre-revenue startups do not generate income in the beginning, they are entirely on the funds of the investors. Pre-revenue valuation is important as the investors will get to know if they are investing in a promising business. It is also important for entrepreneurs to understand where they stand in the market and how they can raise funds.?

Challenges of valuing pre-revenue startups

Valuations of pre-revenue companies are highly speculative due to a lack of historical financial performance. They are unable to rely on previously determined business models, and therefore, traditional models are not applicable here. Investors must consequently trust projections, which increases the risk of over-projection of upper possibilities and under-projection of intrinsic weaknesses. Here are a few challenges that come along:

Insufficient Financial Background

Proper records of a company's revenues, profit margins, and expenditures are crucial to its valuation. This information plays a major role in analyzing and predicting the company's future performance. Startups have no profitable financial history; thus, in such cases, traditional valuation methods like discounted cash flow (DCF) are not particularly useful.

?It is not an easy task to assess the future status of a business when there is no income generation at present. So, evaluators must consider other issues such as team composition, competition, and market size.?

Uncertain Business Models

The uncertain nature of the business approach itself poses another difficulty. Early-stage companies frequently don't have a clear plan for how it will generate revenue. It may concentrate more on growth rather than its earnings in the initial stages.

Businesses keep on evolving while trying to set its stand. This makes the valuation process difficult. A new venture can have a good idea but it is uncertain of how to make a profit. Valuation becomes much more speculative in the absence of definitive answers.

The Markets Size and Competitive Environment

The size of a prospective market may well be one of the most important determinants of evaluating a startup. If the company's product is being sold in a fairly large market that has not yet seen adequate responses from other competitors, the company would be seen in a much more positive light. But if the company's product targets a very niche market and there is already competition present, the startup might suffer restrictions in its capability of widening its base.

Finding Comparables

One conventional manner of valuing a pre-revenue startup is to find comparable companies or competitors to gain insight into the market appraisal being carried out. But, there is a difficulty: no two startups can be alike. The existence of a company appears to have broad similarities and may likely be different, be it in technicality, market positioning strategy, or team aspects.?

Early-stage startups may operate in some relatively emerging markets and hence do not possess many competitors in the beginning. If a company truly exhibits such innovativeness, it may not have any reasonable comparables. Those investors must rely on guesses based on partial information.

High burn rates with no takeaway

Pre-revenue startups quickly burn through cash, especially if they target marketing or team composition. Since they have no revenue to cover their costs, they rely solely on investors to fund them.

A startup that has no probability of turning a profit and thus has a high burn rate is likely to receive a lower valuation. Investors worry that they will soon need to raise more capital, risking the dilution of their shares-or failure altogether.

The Role of the Founding Team

Another major factor in valuing pre-revenue, early-stage startups is the role of the founding team. Frequently, investors are backing the people behind the business rather than the business itself. With a skilled, experienced, and motivated team, there is no telling between a successful implementation of a great idea and ending up with serious entrepreneurial failure.

So, what can be the valuation for such a team? Past successes can only be taken into account; seemingly, the only additional inputs here are industry-related experience and possibly the team's contacts.?

However, predicting their competence to execute this business proposition with utmost success is easier said than done. A truly extraordinary founder is capable of adapting to a changing market. Not so with a rather inflexible team. Hence, investors need to consider these intangible variables in this valuation process.?

Get Pre-revenue Startups Valuation with Eqvista!

To make this valuation process easy and accurate, it is a good option to get an expert’s assistance like Eqvista. We use the most accurate methods of valuation such as Berkus Method, Scorecard Method, Risk Factor Method and VC Method.?Various valuation techniques increase the accuracy of the process and hence add value to the startup.

Eqvista uses software that reduces valuation errors and facilitates cap table management, offering an overview of a company's ownership structures. It is now easy to get your valuation report with our valuation software . To get an accurate valuation, Get in touch with us!