Every startup starts with no revenue. What are you worth at that very early stage?
How do investors value your company if you’re not making a single dollar?
It’s totally possible, and here I’m sharing three actionable ways that you can determine the value of your pre-revenue startup, with straightforward explanations. (Promise.)
Why is valuation important for early founders?
As a quick overview, valuation is a key factor in future fundraising.
The value of your company plays a role in what you give up in equity, related to the funding received in the said round. It also impacts your company’s “curb appeal”.
Your appeal trickles into every business relationship you have, from investors to company acquisition, attracting PR opportunities, and attracting your ideal, paying customers.
It’s not the sole factor to consider, but it’s still a necessary consideration.
Additionally, the valuation of a company is temporary and may not always be agreed upon between founders and investors (a well-known dramatized example of this is Shark Tank negotiations).
Overall, your startup’s valuation is dependent on many variables (noted below) and may not always be clear. It’s important to make sure you are clear and in relative agreement with investors on this prior before moving into early funding meetings and negotiating your term sheet.
How do you value a startup without revenue?
While it seems impossible, revenue isn’t the only factor that shows your company is worth something.
How do you value a startup pre-revenue?
Your company can be valued according to several other factors:
- Your ability to attract and align with your customers without massive costs (customer acquisition costs).
- Your current base of customers. (The larger the better.)
- Your ability to grow in a short time and on a minimal budget and bootstrapping efforts. This comes down to your growth rate.
- Your intellectual property protections such as patents and trademarks.
- Ability to provide a prototype or more fully realized model of your product to potential investors.
- The experience, skills, determination, and connections of the founding team. Any one of these areas is critical. Having all factors proves your team is pushing forward.
All of these factors play into the negotiation with the infamous term sheet in sitting down to investor meetings.
As you might have noticed, a lot of these factors are qualitative. That’s the nature of the beast in startup valuation. You can’t rely on other methods that apply for traditional business models. Startups are risky and require a different way of thinking about value and measuring success.
Now we get into it:
How is valuation actually calculated?
The answer is several ways.
There are several paths to take to reach valuation, some are more complex than others (ex. First Chicago Approach which I won’t dive into here, but will do so in a future blog post along with other startup valuation methods).
I’m going in depth on three in particular, that are widely used and common rules of thumb in early (pre-money) valuation. These are what you need to know now.
Bear in mind that you may need second opinions on valuations through other trusted advisors, investors and other connections. Do not discount the input of others in this journey.
You startup is your baby.
What are the three methods of pre-money valuation?
Angel investors are your first source of funding (you can see how to find and approach angels here). They typically invest in companies in the earliest rounds of pre-seed and seed funding.
In early seed funding rounds, angel investors use three major ways to value a startup.
All are worth becoming intimately familiar with.
This startup valuation method was developed in the ’90s by an angel investor, Dave Berkus, for angel investors.
The method relies on valuing five core elements to determine overall risk in a young company, removing the need to dive into number crunching the finances. *sighs in relief*
The method has been refined over the years to reflect the present times (account for inflation) for startups. The most recent update being in 2016.
The core elements of calculation include having the following:
- Sound idea (assess basic value and risk)
- Prototype (technology risk)
- Quality Management Team (reduce risk in the execution of ideas)
- Strategic Relationships (reduce market risk and competition risk)
- Product Sales/Rollout (reduce risk in production)
All individual factors contribute a maximum of $500,000 to the company value, meaning the sum of all factors tends to lead to a max valuation of $2 million (generally speaking).
This method is flexible based on the location of the startup, and factors that are more appropriate to the startup. For a biotech startup, regulatory approval might be a key part of assessing market risk. A startup in New York may have a higher maximum value (over $2 million) compared to a startup in Iowa.
In calculating, you’ll want to assign a value to each of the value factor areas listed above. The assigned value should aim to fall between 0 and $500,000.
You’ll then add all the assigned values together to reach your valuation (pre-money valuation).
Example fictitious company:
- Sound idea (assess basic value and risk): $300,000
- Prototype (technology risk): $215,000
- Quality Management Team (reduce risk in the execution of ideas): $410,000
- Strategic Relationships (reduce market risk and competition risk): $100,000
- Product Sales/Rollout (reduce risk in production): $145,000
Total = 1,170,000 = Pre-Money Valuation
Venture Capital Method
This method is often the rule of thumb in valuing early-stage startups, without the complexities of methods like the First Chicago approach.
The Venture Capital (VC) Method was devised by Professor Bill Sahlman of Harvard Business School. Essentially, his method relies on the revenues of established businesses in the same industry to estimate a projection for the next 4-7 years at the time of exit (selling your company).
As the name implies, it’s also used by venture capitalists.
What is the formula for valuing a company under this method?
Post-Money Valuation: Exit value ÷ return on Investment (ROI)
The exit value or terminal value is based on future value and like the Berkus Method, needs to account for inflation. As such, be aware that you need to account for the time value of money.
To come up with the exit or terminal value, you multiply the revenue anticipated in the next 4-7 years from comparable companies in the industry and multiply by 2, which is the usually assumed sales multiple:
For example, in 4 years your company is anticipated to generate 30 million per year. Your exit value would look like the following:
$30 million X 2 = $60 million
To move on to calculate ROI and complete our calculation, you need to make another assumption. Early-stage startups are risky. We’re not beating around the bush here.
You need to assume a value of 10-20x in terms of ROI. Investors want to see the bang for their early invested dollars.
Taking that back to our equation:
$60 million/10x = 6 million = your post-money valuation
To get to the value you want, the pre-money valuation, you’ll need to subtract the estimated investment round you’ll need to get up and running.
Say you need $2 million to get up and running. You’ll then reach your pre-money valuation of $4 million.
You can take it a step further to determine the VC ownership in post-money valuation terms.
Divide the investment value by the post-money valuation. In this instance, this is $2 million/$6 million which then results in a VC ownership of 30%.
This method is a common method relied on by angel investors. It uses the data of previous startups in similar regions.
You can also look at connecting with individuals that are proficient in startup valuation, such as this list generated through AngelList.
From the average valuation of startups in your same location, your startup can be more specifically valued in taking account of a handful of other factors that are unique to you.
Each factor carries a certain “weight” in the scorecard valuation.
These factors include:
- Team Strength (0-30%)
- Opportunity Size (0-25%)
- Technology/Product (0-15%)
- Competitive Environment (0-10%)
- Marketing/Sales Avenues/Connections/Partnerships (0-10%)
- Need for Additional Investment (0-5%)
- Other (0-5%)
As you can tell, have an excellent team is literally everything. If you don’t have a team that’s all-in, skilled, and willing to make big things happen, you are more likely to sink rather than swim. Investors, advisors, and experienced founders know this.
In calculating valuation with this method, you need to reach the factor value by multiplying the max range percent by your company’s percent “fulfillment” of that factor.
Your team could use a key hire (VP of Sales). Your team is 85% in meeting that maximum of 30%.
Your factor is 30% x 85% = 0.25.
You would then go through the whole list to compare your current attributes to the max percent weight for each factor.
From there, add the sum of all calculated factors (expressed as decimals) and multiply by the average valuation you found in your previous research.
Continuing the sample calculation:
You determine that your total sum of factors is 0.95.
You’ll take this and multiply this by the average valuation for pre-revenue startups like your own (ex. $6 million).
0.95 x $6 million = $5.7 million
This is your pre-money valuation.
How do you calculate a business based on profit?
Once you reach the point of making revenue, you’ll rely on more specific methods of reaching valuation. These methods will be less applicable.
This will require you to get into the heavier number crunching, understand your existing cash flow, and reach a more specific valuation.
Meaning, it’s time to call up your CFO.
How do you value a company with negative net income?
Great question. How do you value a company losing money?
This question does get tossed around: Why would a company with negative earnings be worth anything?
The reality is that many startups begin their journey with negative cash flow in order to find traction with their ideal customer base. It may take several years before things flip toward being cash-flow positive.
Negative earnings don’t equal a worthless company. It’s often the prerequisite struggle for many founding teams to find their footing.
In terms of calculating valuation, you can can still make use of these methods to derive a ballpark value of valuation as these methods take into account qualitative and quantitative factors that don’t rely on your current financials to dictate.
Bottom line, what’s the easiest way to calculate pre-money valuation?
Easy options still require a bit of research.
A fair calculator for valuing startups without revenue is this online valuation estimator.
That being said, do not rely on online calculators to form serious valuations. Use them to guide as a ballpark figure, and get secondary opinions, and use the above common methods to calculate.
Get additional input. The success of your startup depends on your efforts in these early stages.