What is Your Startup Company Worth?
What is Your Startup Company Worth?
Pre-revenue startup valuation can be a tricky endeavor. There are many things to take into consideration, from the management team and market trends to the demand for the product and the marketing risks involved. After evaluating everything, even with the most effective pre-money valuation formula, the best you can hope for is still just an estimate
Essentially, a 409A valuation is an appraisal of the fair market value of your startup company’s common stock. … A 409A valuation will determine a “strike price” (the price at which your employees can buy equity in your company) that must be at or above fair market value
This is why private companies generally seek out a 409A valuation from an independent valuation services firm before issuing options.
Section 409A of the United States Internal Revenue Code regulates nonqualified deferred compensation paid by a “service recipient” to a “service provider” by generally imposing a 20% excise tax when a certain design or operational rules contained in the section are violated.
For the purposes of these rules, it is hereby clarified that, till a registered valuer is appointed in accordance with the provisions of the Act, the valuation report shall be made by an independent merchant banker who is registered with the Securities and Exchange Board of India or an independent accountant.
How do you value a startup company?
- Typical Business Valuation Approaches:
- Cost / Asset Approach
- Net asset value method
- Income Approach
- Discounted cash flow method
- Single period capitalization
- Market Approach
- Guideline public company method
How do you value a startup company without revenue?
Pre-revenue startup valuation can be a tricky endeavor. There are many things to take into consideration, from the management team and market trends to the demand for the product and the marketing risks involved. Only 1 in 1000 startups meet their goals.
Typical Methods Used:
1. Berkus Method
The method assigns a number, a financial valuation, to each of four major elements of risk faced by all young companies – after crediting the entrepreneur some basic value for the quality and potential of the idea itself. Today, the method as explained adds $500,000 in value for each of the following risk-reduction elements:
Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post-roll-out value of up to $2.5 million), but certainly also allow the investor to put much lower values into each test, resulting in valuations well below that amount. Investors should be able to envision the company breaking $20M within five years.
2. Scorecard Valuation Method
This is one of the more popular startup valuation methods used by angel investors. It’s also known as the Bill Payne valuation method, and it works by comparing the startup to others that are already funded.
To begin, you determine the average valuation for pre-revenue startups in that market space. After that, according to Forbes, you can determine how the startup stacks up against others in the same region by assessing the following factors:
- Strength of the Management Team (0–30%)
- Founding Team – The value will vary dramatically depending on the background and experience of the founding team. Jeff Bezos or Mark Zuckerberg could make a 10% stake in a new tech startup worth a nine-figure investment, whereas your computer-illiterate pal Joe may only be able to command a few hundred bucks for the same stake.
- Size of the Opportunity (0–25%)
- Market Size – You may have some warm leads interested in your pilot product. The bigger your potential market is, the better, especially if you have leads that are ready to buy.
- Traction and Expected Near-Term Revenues – If you have just a few cold leads that aren’t ready to buy, your valuation won’t be as high. The finished product will still be worth something, but ideally, you’ll have enough traction with 50-100 customers so investors can see the potential for revenue in the short-term. It’s also important to consider that 1 potential customer for a $50K product is a riskier than 10 potential customers for a $5K product.
- Product/Technology (0–15%)
- Competitive Environment (0–10%)
- Competition – Entering a market full of high-level competition is a risk, and your valuation will drop as a result. If you have a unicorn startup, you can lay claim to an open market space with no competition, and command much higher investment.
- Marketing/Sales Channels/Partnerships (0–10%)
- Growth and Engagement – Ideally, you should be able to prove your user base is growing, and that people are engaged. If you have an app, 100,000 sporadic users are worth less than 20,000 loyal fans who use it every day. Also, a shrinking user base is a red flag that needs to be addressed quickly if you want to attract investors.
- Need for Additional Investment (0–5%)
- Other (0–5%)
Like many methods, ranking these factors is a very subjective process. Just keep in mind that scalability and the team are the top concerns. As Payne states, “In building a business, the quality of the team is paramount to success. A great team will fix early product flaws, but the reverse is not true.”
3. Venture Capital (VC) Method
The Harvard Business School Professor Bill Sahlman made the VC method popular.
The VC method is a 2-step process that requires several pre-money valuation formulas.
First, we calculate the terminal value of the business in the harvest year.
Secondly, we track backward with the expected ROI and investment amount to calculate the pre-money valuation.
Terminal value is the expected value of the startup on a specific date in the future, while the harvest year is the year that an investor will exit the startup. Another term you’ll need to know is the Industry P/E ratio, which is the stock price-to-earnings ratio. For example, a P/E ratio of 3 means the stock is valued at 3 x $1 in earnings.
Calculating terminal value
You need the following figures:
- Projected revenue in the harvest year
- Projected profit margin in the harvest year
- Industry P/E ratio
Once you have your figures ready, use this calculation:
Terminal Value = projected revenue * projected margin * P/E
Terminal Value = earnings * P/E
E.g. A tech company projects a $10M revenue in 5 years, with a profit margin of 10%. The industry P/E ratio is 20.
So, terminal value = $10M * 10% * 20 = $20M
Calculating the pre-money valuation. For the second step, you need the following:
- The required return on investment (ROI)
- Investment amount
Then use this calculation:
Pre-Money Valuation = Terminal value / ROI – Investment amount
So, let’s say a pre-revenue investor wants an ROI of 10x on his planned investment of $1M.
In this case, Pre-Money Valuation = $20M / 10 – $1M = $1M
With this method, we can deduce the current pre-revenue startup valuation to be $1M. With an investment of $1M and assumptions about growth and industry earnings, the company could be worth $20M in five years.
4. Risk Factor Summation Method
This method combines aspects of the Scorecard Method and the Berkus Method to provide a more-detailed estimation focused on the risks involved with an investment. It considers the following risks:
- Stage of the business
- Funding/capital risk
- Manufacturing risk
- Technology risk
- Sales and marketing risk
- Competition risk
- Legislation/political risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each of these risk areas will be scored as follows:
- -2 – very negative (-$500,000)
- -1 – negative for scaling the startup and carrying out a successful exit (-$250,000)
- 0 – neutral ($0)
- +1 – positive (+$250,000)
- +2 – very positive for scaling the startup and carrying out a successful exit (+$500,000)
- Using the Risk Factor Summation Method, the pre-revenue startup valuation will increase by $250,000 for every +1, or by $500,000 for every +2. Conversely, the pre-revenue valuation falls by $250,000 for every -1, and by $500,000 for every -2.
This technique is well-suited when examining the risks that need to managed to make a successful exit, and it can be paired with the Scorecard Method to give a holistic overview of the startup’s valuation.
5. Asset-Based Valuation method (aka Book Value Valuation)
When you’re looking to know how to value a startup company with no revenue, the asset-based valuation may be the easiest method to use, as it offers a solid assessment of the real value of the startup.
This method entails a bit of financial juggling:
- The initial costs of the startup’s assets are offset by impairment costs and depreciation.
- The total value of physical assets is added to balance sheet values. This includes cash-on-hand and accounts receivables.
- Any outstanding debts or expenses will be subtracted from the total to give you the asset-based valuation.
- The problem here is that this method considers the startup in its current state – not how it will be in the future. Investors are more interested in the latter, and so, as an asset-based valuation doesn’t take that into account, this method has some limitation
In this method, you assess the physical assets of the startup and then figure out how much it would take to duplicate the startup elsewhere. No savvy investor would invest more than the market value of the assets, so it’s useful to know this when looking for pre-revenue investors.
For example, a tech startup could consider the outlay on developing their prototype, patent protection, and research and development.
Unfortunately, in a similar way to the Asset-based method, this doesn’t take the future potential into account, nor does it consider intangible assets such as brand value or the current hot trends in the market.
Therefore, as it is quite an objective approach, this is best used to get a lowball estimate of pre-revenue startup valuation.
7. Valuation by Stage
- Estimated Company Value Stage of Development
- $250,000 – $500,000 Has an exciting business idea or business plan
- $500,000 – $1 million Has a strong management team in place to execute on the plan
- $1 million – $2 million Has a final product or technology prototype
COMMON STARTUP VALUATION MISTAKES
You will inevitably make a few mistakes while discovering how to value a startup company with no revenue. Here is a heads up on two big pitfalls you should do your best to avoid.
- Never Assume a Valuation Is Permanent
In the end, a startup will be worth whatever investors are willing to invest in it. As a business owner, you may not agree with every valuation your startup gets. Ultimately, you must remember the variables at play, and understand that no valuation, high or low, is ever permanent – or even correct.
- Never Assume a Valuation Is Straightforward
In business, hardly anything is straightforward.
Traction is Proof of Concept
If you’re wondering how to value a startup company with no revenue, one of the main indicators is traction. You can get the true story of the business by looking at the following:
- Number of Users – Proving you already have customers is essential. The more, the better.
- Effectiveness of Marketing – If you can show you can attract high-value customers for a relatively low acquisition cost, you will also attract the attention of pre-revenue investors.
- Growth Rate – Showing that your business has grown on a small budget is great, as many investors will see the growth potential when you have some financial backing.
There is a common thread between these three concepts, as a powerful marketing strategy will lead to impressive growth. When that happens, user numbers will surge. Therefore, by providing proof that you have a viable, scalable business idea, you automatically add value to your startup. Investors start to see their dollars as fuel for the fire.
The Value of a Founding Team
Pre-revenue investors want to be sure they are backing a team that is destined for success. They will consider the following:
- Proven Experience – If the team includes people with prior success with other startup ventures, it will be more tempting than a startup full of inexperienced first-timers.
- Skills Diversity – Ideally, a startup team will have a mix of experts whose skills complement each other. A prodigious programmer cannot do everything alone, but if she teams up with a marketing expert, the startup is worth more.
- Commitment – Having great people is only part of the puzzle. Those people need to have the time and dedication to make sure the startup gets off the ground. The team of part-time employees will not be attractive.
Regardless of which pre-money valuation formula you use, a prototype is a game-changing addition. Being able to show pre-revenue investors a working model of your product not only proves you have the tenacity and vision to bring ideas into reality, but it propels the business that much closer to a launch date.
If you have a Minimum Viable Product (MVP) and some early adopters, you could attract investments in the range of $500K to $1.5M.
A working prototype could net you even more if your company is reviewed with the valuation-by-stage method, which is used by many venture capitalists and angel investors. This may result in an investment between $2 million and $5 million.
Supply and Demand
If you operate in a market where the number of business owners dwarfs the number of willing investors, then your startup valuation will be impacted. In such a competitive scenario, many business owners are desperate to get investment, and may even sell themselves short to do so.
Conversely, let’s imagine you have a rare patented idea for a tech startup that has been making waves in the industry. This could drive demand among investors, which will make your startup more valuable.
Emerging Industries and Hot Trends
In booming industries like AI or mobile gaming, many investors will be more willing to pay a premium. The digital age is alive with opportunities that people view as “the next big thing”, so your startup can be worth more if it’s in the right industry.
Products with low-profit margins are not that appealing to investors. On the other hand, a high-growth startup with high margins and promising forecasts for further revenue growth may be able to command larger investments.
If you are trying to raise capital for your start-up company, or you’re thinking of putting money into one, it’s important to determine the company’s worth.
- Start-up companies often look to angel or investors to raise much-needed capital to get their business off the ground – but how does one value a brand new company?
- Start-ups are notoriously hard to value accurately since they do not yet have operating income or perhaps even a salable product yet and will be spending money to get things going.
- While some approaches like discounted cash flows can be used to value both start-ups and established firms, other metrics like cost-to-duplicate and stage valuation are unique to new ventures.