A lot of startup valuation relies on guesswork and estimation, meaning that there is no single, universally accepted analytical methodology for investors. Instead, VCs and Angels will draw upon several valuation method frameworks to understand the value of a startup.
The use of such 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.). We’ll be looking at the most commonly used early-stage and pre-revenue startup valuation methods used by Angels and VCs.
This 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.
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.
Based on Seedrs data, as of 2019, pre-money valuations vary from £750,000 to £2m for seed stage, pre-revenue companies.
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:
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.
If this sounds a little complex, don’t worry. We’ve created an interactive tool that does these calculations for you — all you have to do is answer the questions. Check out our startup valuation calculator here.
The VC method was first introduced in 1987 by Harvard Business School Professor Bill Sahlman. It works out pre-money valuation by first determining post-money valuation, using industry metrics.
The concept is simple and stems from the following equations:
Since; ROI = terminal value / post-money valuation;Then; post-money valuation = terminal value / anticipated ROI
Let’s break it down to take a closer look:
Terminal value is the anticipated selling price for the company at some point in the future — assume 5 to 8 years as the average for early-stage equity. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of sale and, based on those revenues, estimating earnings in the year of the sale.
E.g. a SaaS company with revenues of £20m upon exit might expect to have post-tax earnings of 15% or £3m. Using available industry-specific PE ratios (price to earnings), a 15x PE ratio for our SaaS company would give an estimated terminal value of £45m.
Anticipated ROI: since all investments must demonstrate the possibility of a 10–40x return (as per industry norms for early-stage investments), let’s assume 25x for example. We can now use this information to calculate the pre-money valuation.
Assuming our SaaS entrepreneur needs £500,000 to achieve positive cash-flow and will grow organically thereafter, here’s how one can calculate the pre-money valuation of this transaction:
Post-money valuation: £45m / 25x = £1.8mPre-money valuation: £1.8m — £500,000 = £1.3m
What if there is a need for subsequent investment? An easy way to adjust the pre-money valuation of the current round is by reducing this by the estimated level of dilution from later investors.
Dave Berkus is a widely respected lecturer who has invested in more than 80 startup ventures. Dave’s model first appeared in a book published by Harvard’s Howard Stevenson in the mid-1990s and has been used by Angel investors ever since.
The most recent 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:
Note that the numbers are the maximum for each class so a valuation can be £800,000 (or less) as easily as £2.0m. Furthermore, Dave 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.”
This approach considers a much broader set of factors in determining the pre-money valuation of pre-revenue companies. The Ohio Tech Angels, who developed this method, describe it as follows…
“Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘management risk’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types,” including: management, stage of the business, legislation/political risk, manufacturing risk, sales and marketing risk, funding/capital raising risk, competition risk, technology risk, litigation risk, international risk, reputation risk, potential lucrative exit.
The average pre-money valuation of pre-revenue companies in your industry is then adjusted positively by £200,000 for every +1 (+£400,000 for a +2) and negatively by £200,000 for every -1 (£400,000 for a -2).
In summary, good practice suggests using at least three methods to estimate the appropriate pre-money valuation. If all give roughly the same number, simply average the three. If one is an outlier, then average the other two, or alternatively use a fourth method in an attempt to bring three of them in close agreement.
For more information, check out our comprehensive guide: The Art of Startup Valuation: A Guide for Early-Stage and Pre-Revenue Startups.