Pre-Revenue Startup Valuation
Pre-revenue startup valuation is a challenging and often contentious issue. Unlike established businesses that have a track record of revenue and profit, startups are often valued based on potential, and this can make determining their worth a difficult task. However, there are some methods and factors that can be used to evaluate the value of a pre-revenue startup.
A startup valuation is different from valuing an established company. It is always an interesting task as it involves predicting the future success of a business that has no revenue yet such as an ecommerce business, using both quantitative and qualitative financial analysis and projections.
Angel investors tend to value a startup business that is at the stage of pre-revenue or pre-money valuation (i.e. before external investments) through assessing the entrepreneur and the management team. One method used to value pre-revenue startups is the discounted cash flow (DCF) model. This model takes into account the expected cash flows of the company over a period of time, and discounts them back to the present value. The expected cash flows are based on projected revenues and expenses, which can be difficult
Valuation Methodologies Often Used By Investors For Pre-Revenue Startups:
1) The Scorecard Valuation Method (or The Bill Payne Valuation Method)
This is one of the methods most preferred by investors. It compares the evaluating startup with other similar funded startups on various factors like regional trends, market conditions and the startup’s status, to derive a more realistic average valuation.
The method begins with determining the startup’s average pre-money valuation. For this, angel investors would explore the valuation data of relevant startups using a baseline identified from examining the existing pre-money valuations across regions.
Thereafter, A Comparison Is Done Across Relevant Startups In The Same Region Using The Following Factors:
✔ Strength of Management team
✔ Size of Opportunities
✔ Product or Technology used
✔ Degree of competition in the market
✔ Marketing strategies / Partnerships / Sales opportunities
✔ Additional investments required
✔ Miscellaneous
2) Venture Capital Method
Introduced and popularized by Harvard Business School Professor Bill Sahlman, this method derives the pre-money valuation from the post-money valuation, using industry metrics.
The equations used in this method are:
Post-money Valuation = Divided Terminal Value / Expected Return On Investment (ROI)
Pre-money Valuation= Post-money Valuation – Investment
Terminal Value, otherwise known as the Exit Value, refers to the anticipated value of the startup’s assets at a certain date in the future, usually from 4 to 7 years.
The time value of money plays a crucial role so the Terminal Value has to be translated to present time for a more realistic approach.
3) The Berkus Method
This method uses both qualitative as well as quantitative factors to calculate the following five elements involved in the valuation of a pre-revenue startup:
- Basic value
- Prototypes for reducing technological risks
- Quality of the Management team in reducing execution risk
- Strategic Relationships for reducing market risks
- Strategies of sales or product rollout for reducing production risk
This method fixes up the hurdle number to $20 million in the fifth year of the business, and provides an opportunity for investors to achieve a 10 times increment in the value of the business during its lifespan.
Example:
Another example of a pre-revenue startup valuation is the case of Snapchat, a social media platform founded in 2011. In its early stages, Snapchat had no revenue but had a valuation of over $800 million by 2013.
Snapchat became popular due to its unique feature of allowing users to send photos and messages that disappeared after a short period of time. This attracted a large user base, particularly among younger demographics, and the company was able to secure significant investment from venture capitalists.
Snapchat’s valuation was based on its potential to monetize its user base through advertising and other revenue streams, despite not having any significant revenue at the time. The company has since gone public and has generated significant revenue through advertising and other sources, proving the validity of its valuation.
Conclusion
The valuation models for startups involve numerous assumptions since there is not much hard data available to work with. Hence the results contain substantial levels of estimations and approximations. There is no definite way to value a business still in its birthing stage. However, these valuation methods have proved to be useful at certain points of the startup development.
Other methods not discussed here include the First Chicago Method, the Valuation Using Multiples Method, the Comparable Company Analysis (CAC) method, the Discounted Cash Flow (DCF) method and the Cost-to-Duplicate method.
Contact us for a free initial consultation for your startup valuation. Read on to find out some key decisions startup founders have to make.
