How to value pre-revenue Start-ups?

Lot of times we wonder how do we value a pre-revenue startup. Below are the details which we may consider while valuing start-ups:

Valuing a Startup with No Revenue (Pre revenue)

Pre-revenue startup valuation can be difficult and complex too. There are many factors involved, from the management team and market trends to the demand for the product and the marketing risks, business risks involved.

Even after evaluating everything, the best you can hope for is still just an estimate.?

Important factors for pre-revenue startup valuation

1)????Traction - Proof of Concept

1.??????Number of Users – One of the most important POC is to establish the fact that you already have a customer base.

2.??????Effectiveness of Marketing – If you can attract high-value customers for a relatively low acquisition cost, you will also attract the attention of pre-revenue investors.

3.??????Growth Rate – If the business till now has grown on a small budget, investors can predict on how much the future growth will be after some financial backing.

All these factors are interrelated and by providing proof that you have a viable, scalable business idea, you automatically add value to your startup.

2)????Founding Team

·??????Proven Experience?– prior success with other startups

·??????Skills Diversity?– team with skills complementing with each other

·??????Commitment?– people working dedicatedly on the project depicts focus

3)????Prototypes/ MPV

Irrespective of pre-money valuation method, a prototype is a game-changing addition. Being able to show pre-revenue investors a working model of your product not only proves you have the tenacity and vision to bring ideas into reality, but it propels the business that much closer to a launch date.

Minimum Viable Product (MVP) and some early adopters: could attract investments in the range of $500k to $1.5million.

Working prototype: May result in investment between $2 to $5 million.

4)????Supply and Demand

If businesses in a market are significantly more than the investors, then founders will have tough time finding investors. If they find someone, then valuations shall be low.

On the other hand, if a business has a rare patented idea, it could drive demand among investors, which will make your startup more valuable.

5)????Emerging Industries and Hot Trends

AI/ML, Mobile Gaming, Blockchain/Crypto, NFTs attract investors that too with a premium now a days.

6)????High Margins

A high-growth startup with high margins and promising forecasts for further revenue growth may be able to command larger investments. On the other hand, vice versa is not that attractive

5 Common Methods Used By Investors To Value Pre-Revenue Companies

Method 1: Berkus Method

The angel investor Dave Berkus thinks investors should be able to envision the company breaking $20M within five years. His method assesses five critical aspects of a startup:

·??????Concept?– The product offers basic value with acceptable risk.

·??????Prototype?– This reduces technology risk.

·??????Quality management?– If it’s not already there, the startup has plans to install a quality management team.

·??????Connections?– There are some strategic relationships in place already, which reduces competitive risks in the market.

·??????Launch plan?– There is some evidence of a sales plan and preparation for product rollout. (This doesn’t apply to all pre-revenue startups)

Each aspect is given a rating up to $500,000, which means the highest possible valuation is $2.5 million.

The Berkus Method is a simple estimation, often used for tech startups. It is a useful way to gauge value, but as it doesn’t take the market into account, it may not offer the scope some people desire.

Method 2:?Scorecard Valuation Method or Bill Payne Valuation Method

This is one of the more popular startup valuation methods used by angel investors. It’s also known as the Bill Payne valuation method, and it works by comparing the startup to others that are already funded.

To begin, you determine the average valuation for pre-revenue startups in that market space. After that, according to Forbes, you can determine how the startup stacks up against others in the same region by assessing the following factors:

a)????Strength of the Management Team (0–30%)

Founding Team – The value will vary dramatically depending on the background and experience of the founding team.

b)????Size of the Opportunity (0–25%)

Market Size –The bigger your potential market is, the better, especially if you have leads that are ready to buy.

Traction and Expected Near-Term Revenues –Ideally, you should have enough traction with 50-100 customers so investors can see the potential for revenue in the short-term.

c)????Product/Technology (0–15%)

d)????Competitive Environment (0–10%)

Entering a market full of high-level competition is a risk, and your valuation will drop as a result. A monopolistic business shall attract valuation at premium.

e)????Marketing/Sales Channels/Partnerships (0–10%)

Growth and Engagement - If you have an app, 100,000 random users are worth less than 20,000 loyal fans who use it every day. Further, a shrinking user base is a red flag that needs to be addressed quickly to attract investors.

f)?????Need for Additional Investment (0–5%)

?g)????Other (0–5%)

Like many methods, ranking these factors is a very subjective process.

As Bill Payne states, “In building a business, the quality of the team is paramount to success. A great team will fix early product flaws, but the reverse is not true.”

Method 3: Venture Capital (VC) Method

The Harvard Business School Professor Bill Sahlman made the VC method popular.

The VC method is a?two step process that requires several pre-money valuation formulas.

1.??????Calculate the terminal value of the business in the harvest year.

2.??????Then, track backward with the expected ROI and investment amount to calculate the pre-money valuation.

Terminal value is the expected value of the startup on a specific date in the future, while the harvest year is the year that an investor will exit the startup. Another term you’ll need to know is the Industry P/E ratio, which is the stock price-to-earnings ratio. For example, a P/E ratio of 5 means the stock is valued at 5 x $1 in earnings.

Calculating terminal value

You need the following figures:

·??????Projected revenue in the harvest year

·??????Projected profit margin in the harvest year

·??????Industry P/E ratio

You can research online to find industry average PE and Margins.

Once you have your figures ready, use this calculation:

·??????Terminal Value = projected revenue * projected margin * P/E

·??????Terminal Value = earnings * P/E

E.g. A tech-company projects a $20M revenue in 5 years, with a profit margin of 10%. The industry P/E ratio is 10.

So, terminal value = $20M * 10% * 10 = $20M

Calculating the pre-money valuation

For the second step, you need the following:

·??????Required return on investment (ROI)

·??????Investment amount

Then use this calculation:

·??????Pre-Money Valuation = Terminal value / ROI – Investment amount

So, let’s say a pre-revenue investor wants an ROI of 5x on his planned investment of $1M.

In this case, Pre-Money Valuation = $20M / 5 – $1M = $3M

With this method, we can deduce the current pre-revenue startup valuation to be $3M. With an investment of $1M and assumptions about growth and industry earnings, the company could be worth $20M in five years’ time.

Method 4: Risk Factor Summation Method

This method combines aspects of the Scorecard Method and the Berkus Method to provide a more-detailed estimation focused on the risks involved with an investment. It takes the following risks into consideration:

·??????Management

·??????Stage of the business

·??????Funding/capital risk

·??????Manufacturing risk

·??????Technology risk

·??????Sales and marketing risk

·??????Competition risk

·??????Legislation/political risk

·??????Litigation risk

·??????International risk

·??????Reputation risk

·??????Potential lucrative exit

Each of these risk areas will be scored as follows:

·??????-2 – very negative (-$500,000)

·??????-1 – negative for scaling the startup and carrying out a successful exit (-$250,000)

·??????0 – neutral ($0)

·??????+1 – positive (+$250,000)

·??????+2 – very positive for scaling the startup and carrying out a successful exit (+$500,000)

Using the Risk Factor Summation Method, the pre-revenue startup valuation will increase by $250,000 for every +1, or by $500,000 for every +2. Conversely, the pre-revenue valuation falls by $250,000 for every -1, and by $500,000 for every -2.

This technique is well-suited when examining the risks that need to managed to make a successful exit, and it can be paired with the Scorecard Method to give a holistic overview of the startup’s valuation.

Method 5: Cost-to-Duplicate

Source:?Seed Stage Capital

In this method, you assess the physical assets of the startup and then figure out how much it would take to duplicate the startup elsewhere. No investor would invest more than the market value of the assets, so it’s useful to know this when looking for pre-revenue investors.

Therefore, as it is quite an objective approach, this is best used to get a lowball estimate of pre-revenue startup valuation.

Common startup valuation mistakes

a)????Never Assume a Valuation Is Permanent

You must remember the variables at play, and understand that no valuation, high or low, is ever permanent - or even correct.

b)????Never Assume a Valuation Is Straightforward?

So, even after you get a pre-revenue startup valuation you are happy with, it’s best to discuss things in great detail with potential investors just to make sure everyone is on the same page about how to proceed.