How VCs evaluate Startups - FINALLY REVEALED [2022] ???

Valuing an early stage company is not a precise exercise, even if some experts or mentors might have led you to believe that there is some precision in doing so.

The first question that any Venture Capitalist asks to the Founder is: is the Startups already generating revenue? If yes, what is it's growth/funding stage?

For the aim of this paper, we can better paraphrase in: "is it a pre-revenue or post-revenue company?"

In the case of a post-revenue company (a company which has been already launched and generates a revenue) there are plenty of financial quantitative indicators out there. From the Balance Sheet, Income Statement and the Cashflow Statement one can derive all the relevant metrics to provide with information the Investment Analyst. I will deal with this argument in a future article, where I will provide to the reader a full panoramic about the world of financial assessment.

In this article, I will specifically consider the case of a pre-revenue company, a company that does not generate revenue at all. In some cases, it is a company that doen't formally exist at all. All you have is an accurate Business Plan, a Pitch Deck and, only if you are a meticolous founder, you have some kind of prototypes of proofs of concept (PoC).

Before continuing with the article, let me just remind you that this is a production by HuBibi, a LinkedIn page providing free lessons, tips and Insights about Digital Transformation, Banking, Project Management, Startups and Venture Capital. You can click on the window below to get access to the multitude of videos and articles which are helping a lot of founders and business people in the MENA Region. ??

The use of a specific valuation methods is dependent upon the stage of a business, and the corresponding data points available in the market and/or industry the startup operates in (earnings/revenue/acquisition multiples etc.). In this article, we will be looking at the 3 most "effective" and commonly used early-stage and pre-revenue angel and venture capital valuation methods: the Scorecard Valuation Method, the Dave Berkus Valuation Method and the Discounted Cash Flow Method (DCF).

1. Scorecard Valuation Methodology??

This startup valuation method compares the target company to typical Angel-funded startup ventures and adjusts the average valuation of recently funded companies in the industry, to establish a pre-money valuation of the target. Such comparisons can only be made for companies at the same stage of development.

a.??????The first step is to determine the average pre-money valuation of pre-revenue companies in the business sector of the target company. Pre-money valuation varies with the economy and with the competitive environment for startup ventures within an industry. In most industries, for pre-revenue startups, the pre-money valuation does not differ too significantly from one business sector to another.

b.?????The next step is to compare the target company to your perception of similar deals done in the industry, considering the following:

• Strength of the management team: founders’ experience and skillset, founders’ flexibility, and completeness of the management team.
• Size of the opportunity: market size for the company’s product or service, the timeline for increase (or generation) of revenues, and the strength of competition.
• Product or service: product/market definition and fit, the path to acceptance, and barriers to entry.
• The sales channel, stage of business, size of the investment round, need for financing, and quality of business plan and presentation.

Here is a section of a typical valuation worksheet that has been developed to assess the relative strength of target companies:?

How does it work?

For each comparison factor, like the one shown above, there are a set of multiple-choice questions to answer about your business. The answers give you a score in the range of -3 (worst) to +3 (best). You multiply this score against the comparison factor range (see below), to give each section a weighting, then you sum up the total factor and multiply this against the average pre-money valuation for your industry, giving you your estimated valuation.

2. Dave Berkus Valuation Method?

Dave Berkus?is a widely respected lecturer who has invested in more than 80 startup ventures. The most recent Dave Berkus version, updated in 2009, starts with a pre-money valuation of zero, and then assesses the quality of the target company in light of the following characteristics:?

How does it work?

Based on experience, available data and the knowledge of the specific industry sector (and its market line), one can compare similar situation and try to assign a value (which is arbitrary, not scientifically determined) to each of the previous variable. In other terms, a basic value will be assigned and a series of values will be added for Quality Management, Sound Idea, Working Prototype, Quality Board of Directors, Product Rollouts or Sales.

Note that from the whole sum, one must subtract the values coming as output from the Risk Analysis: Technology, Execution, Market and Production.

Dave, however, reminds us that his method “was created specifically for the earliest stage investments as a way to find a starting point without relying upon the founder’s financial forecasts.” Finally, the maximum one can assign to each of the factors is flexible by geography and discipline.

3. Discounted Cash Flow Method (DCF)??

Businesses can also be valued using the Discounted Cash Flow (DCF) Method. You may need to work closely with a market analyst or an investor to use this method.?

You take your forecasted future cash flows and then apply a discount rate, or the expected rate of return on investment (ROI). In other words, DCF involves?forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth.

Generally, the higher the discount rate, the riskier the investment — and the better your growth rate needs to be.?

The idea behind this is that investing in startups is a high-risk move compared to investing in businesses already operating and earning consistent revenue.

The trouble with DCF is the quality of the DCF depends on the?analyst's ability to forecast future market conditions and make good assumptions about long-term?growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected?rate of return?used for?discounting cash flows. So, DCF needs to be used with much care.

Startup Evaluation Methods: which one is the best?

As I have pointed out, there are several methods which lead to different results. All of these methods are to be intendend not as quantitative in the classical meaning. Given the high degree of unpredictability, these computations represent something in the between qualitative and quantitative determination. Now, given all their pros and cons, which one is the best method?

To respond to the question: Depending on the type of startup valued, analysts will weigh these methods differently to give a final valuation.

Yes, but...what is the rationality behind their choices? Why would they prioritise one method over another?

Given that who is interested in investing in a pre-revenue company is very often an Angel Investor or a Family Office, all of the previous methods favour startups with better profitability prospects. Anyway, in order to chose the method that better suits to your case, let us consider the Pros and Cons of each of the described methods:

1. Pros and Cons of the Scorecard Method

• Pros: covers more areas than the Berkus method, but is still relatively straightforward and easy to apply; doesn’t weigh all areas the same as the Berkus method does; is the method of choice by Bill Payne and David S. Rose and many other angels.
• Cons: requires skill to know how much to credit each area, ignores some areas that the more detailed methods cover, and is dependent on choosing an appropriate benchmark startup valuation to set the maximum value (e.g., $2.5M max vs. $5M max).

2. Pros and Cons of the Berkus Method

• Pros: quick, high-level, and doesn’t rely on forecasts.
• Cons: weighs all five areas the same in terms of importance, requires skill to know how much to credit each area, ignores some areas that the more detailed methods cover, and is dependent on choosing an appropriate benchmark startup valuation to set the maximum value (e.g., $2.5M max vs. $5M max).

3. Pros and Cons of DCF Method

• Pros: can provide an intrinsic value of a business based on estimated future cash flows.
• Cons: “Garbage in, Garbage out”: it’s only as accurate as the cash flows that you predict. It’s highly speculative beyond a few years out, especially for startups where that is where the majority of startup value comes from (i.e. 5-15+ years out). Most appropriate for more mature businesses with predictable growth.

To sum up today’s lengthy topic of valuation methods, I suggest that angel investors and crowdfunding investors practice the following when valuing companies:

1. Practice makes perfect.?There is no substitute for experience. There is no magic formula that will give you exact valuations. The more you practice valuing companies, the better you will become.
2. Keep it simple, especially when starting out. We suggest starting simple and using the Berkus, Scorecard, and Risk Factor methods. As you become comfortable, adjust and try some of the more advanced methods. It’s a matter of investor preference, but also impacted by how much you are investing in a deal.
3. Use multiple methods. Use the football-field approach to visualize ranges and check how the outcomes of different methods compare with one another.