Startup Valuation Methods To Value A Pre-Revenue Startups

Updated 29/8/2022

Startup valuations reveal a company's ability to employ new cash to expand, exceed consumer and investor expectations, and achieve the next goal. Unicorn valuations, or companies worth $1 billion or more, now number in the hundreds. There are now "decacorns," or startups worth $10 billion or more, as well as "hectocorns," or companies worth more than $100 billion.

These calculations, while remarkable, aren't as objective as you may believe. A startup valuation may take into account your team's experience, product, assets, business model, total addressable market, competition performance, market opportunity, goodwill, and other criteria.

What Is Startup Valuation?

For any corporation, valuing its assets is never simple. The task of assigning a valuation to businesses with little or no revenue or profits and uncertain futures is extremely difficult. It's usually a matter of valuing mature, publicly-traded businesses with consistent revenues and earnings as a multiple of their earnings before interest, taxes, depreciation, and amortisation (EBITDA) or based on other industry-specific multiples.

However, valuing a new enterprise that isn't publicly traded and may be years away from sales is much more difficult. There are numerous factors to examine, including the management team and industry trends, as well as product demand and marketing hazards.

Important Factors For Pre-Revenue Starup Valuation

The majority of the time, early-stage firms are valued in the middle, which means that founders don't get as much as they expected and investors may invest higher than they intended. Here are some major elements to consider when valuing a startup before it generates income.

Traction Is Demostration Of Concept

If you are trying to figure out how to value a firm with no income, one of the most important factors to consider is traction. e

  • Number of Users. Demonstrating that you already have clients is critical. The greater the number, the better.
  • Marketing Effectiveness. If you can demonstate that you can recruit high-value consumers for a low acquisition cost, you will draw the interest of pre-revenue investors
  • Growth Rate. Demonstrating that your business has expanded on a limited budget is advantageous, since many investors will see the potential for expansion if you have some funding.

There is a link between these three ideas, as a strong marketing plan will result in significant growth. When that happens, the number of users will skyrocket. As a result, you automatically add value to your startup by demonstrating that you have a solid, scalable business idea. Investors will begin to view their money as fuel for the fire.

The Importance Of A Founders' Team

Pre-revenue investors want to know that they are investing in a team that's going to be successful. They will think about the following:

  • Proven Experience - A startup with personnel who have had previous success with other startups will be more appealing than one with inexperienced first-timers.
  • Skills Diversity - A startup team should ideally consist of a mix of professionals with complementary skills. A brillant programmer cannot do everything on her own, but when she joins forces with a marketing expert, the startup becomes more valuable.
  • Commitment - Great individuals are simple one piece of the puzzle. Those individuals must have the time and commitment to ensure the startup's success. A team of part-time workers will not be appealing.

Prototypes / Minimum Viable Product (MVP)

A prototype is a game-changing addition, regardless of which pre-money valuation method you choose. Being able to display a functioning model of your product to pre-revenue investors not only demonstrates your persistence and vision for turning ideas into reality but also accelerates the business's launch date.

If you have a Minimum Viable Product (MVP) and some early users, you might be able to raise $500k to $1.5M in funding. If your company is evaluated using the valuation-by-stage method, which is utilised by many venture capitalists and angel investors, a working prototype could fetch you even more money. This might result in a $2 million to $5 million investment.

Demand and Supply

Your startup valuation will be impacted if you operate in a market where the number of business owners outnumbers the number of willing investors. Many business owners are desperate for investment in such a competitive environment, and may even sell themselves short to do so.

On the other hand, you have a unique patented idea for a startup that is causing a stir in the industry. This may increase investor demand, increasing the value of your firm.

Hot Trends and Emerging Industries

Many investors will be prepared to pay a premium in booming businesses like Artificial Intelligent (AI) or mobile gaming. The internet age is rife with prospects that many regards as "the next great thing," so if your startup is in the proper field, it could be worth more.

High Margins

Investors aren't interested in high-margin products with low-profit margins. A high-growth business, on the other hand, with good margins and excellent revenue growth estimates, may be able to attract greater financing.

Common Startup Valuation Method

It may seem difficult to perform a pre-revenue business valuation on your own, but you may benefit from the knowledge and wisdom of other entrepreneurs, angel investors, and venture capitalists. Furthermore, by familiarizing yourself with the most common startup valuation methods, you will not only be able to analyze a firm with no revenue but you will also be able to negotiate a better deal with pre-revenue investors.

The Berkus Method

Investors, according to angel investor Dave Berkus, should be able to see the company reaching $20 million in five years. His approach evaluates five key components of a startup.

  • Concept. The product provides basic value while posing a manageable risk
  • Prototype. This lowers the danger of technology failure.
  • Quality Assurance. If it isnts already in place, the startup intends to hire a quality assurance staff
  • Connections. There are already some strategic partnerships in place, which lessens market competitive threats.
  • Launch Plan. There is some evidence of sales strategy and preparation for product launch. (Note that this does not apply to all pre-revenue businesses)

Each facet is assigned a grade of up to $500,000, implying a maximum valuation of $2.5 million. The Berkus Method is a straightforward estimating technique popular among software firms. It is a good technique to estimate worth, but it lacks the flexibility that some people want because it doesn't consider that market.

berkus method/ startup valuation
Berkus Method

Scorecard Valuation Method

Another option for pre-revenue enterprises is the Scorecard Valuation Method. It also compares startups to companies that have already received funding, but with additional criteria.

To begin, first, determine the average pre-money valuation of comparable businesses. Then look at how your company compares to the traits listed below. After that, assign a comparison percentage to each quality. When compared to your competition, you can be on par (100%), below average (<100%), or above average (>100%) for each characteristic.

CriteriaWeightTarget CompanyFactor
Team30%x= 0.3*x
Size Of The Opportunity25%x= 0.24*x
Product/Technology15%x= 0.15*x
Competitive Environment10%x= 0.10*x
Sales/Marketing10%x= 0.10*x
Need For More Financing5%x= 0.05*x
Other5%x= 0.05*x
TotalSum of all factors

For example, you give your e-commerce team a 150% score since it's complete, well-trained, and staffed with experienced developers and marketers, some of whom have previously worked for competitors. To get a factor of 0.45, multiply 30% by 150%.

Calculate the sum of all factors for each startup quality. To calculate your pre-revenue valuation, multiply that sum by the typical valuation in your industry.

Venture Capital (VC) Method

The venture capital approach was popularised by Harvard Business School Professor Bill Sahlman. The venture capital technique is a two-step procedure that necessitates the use of a number of pre-money valuation algorithms.

First, determine the business's terminal value in the harvest year. Second, determine the pre-money valuation by working backwards from the predicted return on investment (ROI) and investment amount. The harvest year is the year in which an investor will depart the firm. Terminal value is the estimated value of the startup at a specific point in the future. The Industry Price-Earning Ratio (P/E ratio), or stock price-to-earnings ratio, is another phrase you will need to grasp. A P/E ratio of three, for example, suggests that the stock is worth three times its earnings.

Calculating Terminal Value

To calculate the terminal value, the following figures are required.

  • Estimated revenue for the harvest season
  • Profit margn forecasted for the harvest year
  • P/E ratio of the industry

You may uncover industry averages for the P/E ratio and predicted profit margins by doing some research online. Once you have gathered your data, perform the following calculation:

  • Terminal Value = earnings x P/E

For example, in five years, a tech company expects to generate $10 million in revenue, with a 10% profit margin. The P/E ratio is 20. As a result, the terminal value is $10 million multiplied by 10% and multiplied by 20 to equal $20 million.

Calculating The Pre-Money Valuation

The following items are required for the second step.

  • Required Return On Investmetn (ROI)
  • Investment Amount

Then calculate it based on the formula below.

Pre-Money Valuation = Terminal value/ROI - Investment amount

Imagine a pre-revenue investor is looking for a 10x return on his $1 million investment.

Pre-Money Valuation = $20M/10 - $1M = $1M in this scenario.

We may calculate the current pre-revenue startup valuation to be $1 million using this method. With a $1 million investment and reasonable growth and industry profits estimates, the company may be worth $20 million in five years.

Risk Factor Summation Method

This approach combines elements of the Scorecard Method and the Berkus Method to produce a more precise evaluation of an investment's risk. It takes into account the following risk:

  • Management
  • Stage of the Company
  • Capital/Funding Risk
  • Manufacturing Dangers
  • Technology Risk
  • Risks in Sales and Marketing
  • Threat of Competition
  • Political/Legislation Risk
  • Litigation Risk
  • International Risk
  • Risk to One's Reputation
  • Potential Lucrative Risk

Each of these risk areas will be given a score based on the following criteria:

  • - 2 (-$500,000) - Extremely Negative
  • - 1 (-$250,000) - Negative for scaling the startup and carrying out a successful exit
  • 0 ($0) - Neutral
  • + 1 ($250,000) - Positive
  • + 2 ($500,000) - Excellent for scaling the business and execiting a successful exit

The pre-revenue company valuation will increase by $250,000 for every +1 and by $500,000 for every +2. For every -1, the pre-revenue value drops by $250,000 and for every - 2, it drops by $500,000.

This method is useful for assessing the risks that must be addressed in order to achieve a successful exit, and it can be combined with the Scorecard Method to provide a comprehensive assessment of the startup's value.

Comparable Transactions Method

Because it is based on precedent, the Comparable Transactions Method is one of the most common startup valuation methodologies. You're responding to the question, "How much did startups like mine cost to acquire?"

Consider the case of Rapid, a fictional shipping firm that was purchased for $24 million. It had 700,000 subscribers on its mobile app and website. That works out to about $34 per user. Your shipping company has a user base of 120,000 people. This gives your company a market value of around $4 million.

You can also look up revenue multiples for companies in your industry that are similar to yours. It's possible that SaaS companies in your market produce 5x to 7x the prior year's net sales.

You must include ratios or multipliers in any comparison model for everything that is significantly different between your two businesses. If another SaaS company has proprietary technology and you don't, for example, you might want to choose a multiplier on the lower end of the spectrum, such as 5x (or lower) in our example.

Cost To Duplicate Approach

This strategy involves evaluating the firm's tangible assets before calculating how much it would cost to replicate the startup elsewhere. When looking for pre-revenue investors, it's helpful to remember that no wise investor will invest more than the assets' market value.

A tech startup, for example, might think about the costs of producing their prototype, patent protection, and research and development. Unfortunately, this strategy does not account for future possibilities, nor does it incorporate intangible assets such as brand value or current market hot trends.

As a result, because it is such an objective approach, it is best utilised to acquire a lowball estimate of a startup's pre-revenue worth.

Conclusion

You must balance all of the things that your startup must supply in order to present yourself with the highest valuation for your pre-revenue business. Before approaching individuals who might be interested in investing in your company, it is equally critical that you, as the owner, learn how to value it.

Experimenting with different valuation methodologies will allow you to show your investors that your company has the ability to grow and is worth their money.

Reference

Startup Validation Method

What Is Startup Valuation

Startup Valuation

Understanding Startup Valuation

Related Posts

Subscribe for more right in your inbox!

Thousands of subscribers cannot be wrong! Get Startup insights right in your inbox. 
We will only use your email to send you insights once a month - no spam!
Subscribe To Our Startup Insights

Written by Cherylle Phua

How useful was this post?

Click on a star to rate it!

Average rating 0 / 5. Vote count: 0

No votes so far! Be the first to rate this post.

Leave a Reply

Your email address will not be published. Required fields are marked *

Subscribe To Our Startup Insights
© COPYRIGHT NEXEA, ALL RIGHTS RESERVED. PRIVACY POLICY. TERMS OF USE.
OUR STARTUP NETWORK
CORPORATE ACCELERATORNEXEA INNOVATION
ENTREPRENEURS PROGRAMME