Mature, publicly listed businesses with steady revenues and earnings are commonly valued as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA) or based on other industry specific multiples. However, valuing an early stage company is fundamentally different. Startups are more often than not at a pre-revenue stage in their life-span so there aren’t any hard facts or revenue figures to base the value of the business on.
Ambiguous as it may sound, company valuation is still a crucial part of early stage startups when they want to raise money. Therefore, an estimation has to be used, which is why several startup valuation method frameworks have been invented to help investors and startups themselves more accurately guess the company valuation. Business owners want the value to be as high as possible, whilst investors want the value to be low enough that they’ll see a big return on their investment. In this post, we will introduce 5 common models that angel investors and early stage VCs use to evaluate early stage startups.
1. Different models to calculate startup valuation
1.1. Venture Capital Method
The VC Method was first made popular by Harvard Business School Professor Bill Sahlman in 1987. It is one of the useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The method uses the following formulas:
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
Post-money Valuation = Terminal Value ÷ Anticipated ROI
Terminal (or Harvest) value is the startup’s anticipated selling price in the future, estimated by using reasonable expectation for revenues in the year of sale and estimating earnings.
- The Math:
Assuming your startup is raising $100,000 to get a positive cash flow and expecting to be generating $2 million in revenues when you sell the company in 5 years while your investor targets return of investment of 20X we can do the following calculations.
First, we need to find a multiple to compute the terminal value of your startup. In short, multiple is a value, typically expressed as a factor, used to multiply a business economic benefit to arrive at the business value. Generally, there are numerous multiples can be used to calculate a business’ value, such as price-earnings ratio (P/E ratio), enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio, price-to-book ratio (P/B), EV/sales ratio, etc.
In this example, with the projecting sales of $2 million, we will use the EV/sales ratio of 5, a common number for early stage startups, to proceed to the next step.
- Terminal Value = Revenue * Market Multiple = $2 million * 5 = $10 million
- Post-money Valuation = Terminal Value ÷ Anticipated ROI = $10 million ÷ 20X
- Post-money Valuation = $500,000
- Pre-money Valuation = Post-money Valuation – Investment = $500,000 – $100,000
- Pre-money Valuation = $400,000
So, the pre-money valuation of the company is $400,000.
The above formula demonstrates the venture capital method in its purest form. If, however, the startup is likely to need additional capital prior to an exit event where the investor can liquidate her investment, she will be diluted by the follow-on issuance if she does not participate in the next round. A simple manner to address the threat of future dilution is to make a strategic guess as to the future capital needs of the firm and calculate what level of dilution that would be.
So, continue with the above example, let’s say after some calculations for all the possible scenarios, we come up with the projected dilution of 30%. With the dilution of 30%, the pre-money valuation is reduced to $280,000.
While being the dominant method used in early stage investment, the VC Method has numerous shortfalls:
- VC method requires reliance on projected growth and future revenues. With regard to income-based valuation methods, projecting company revenue at a future date is extremely difficult and speculative.
- VC method relies upon valuation multiples in deriving a terminal valuation. All of the issues identified in market-based valuations make this method less certain.
- The discount rate of return or multiples required by investors is a subjective determination based upon the perceived risk of a given investor. There is no fixed method for assessing the risk associated with the subject business.
- Investors that are not coming from the Venture Capital industry and have different logics in evaluating opportunities might not embrace this approach to company valuation
1.2. Berkus Method
The Berkus Method is meant for pre-revenue startups, it is a simple and convenient rule of thumb to estimate the value of your company. It was designed by Dave Berkus, a renowned author and business angel investor. The Berkus Method uses both qualitative and quantitative factors to calculate a valuation based on five elements:
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
Each element then will be assigned a monetary value of up to $500K, giving the opportunity for a pre-money valuation of up to $2M – $2.5M. Berkus sets the hurdle number at $20M (in the fifth year in business) to “provide some opportunity for the investment to achieve a ten-times increase in value over its life.” Let’s take a look at the example below to understand the general rules of the Berkus Method:
|Elements to consider:
|Add to Company Value up to:
|Sound idea (basic value)
|Prototype (reducing technology risk)
|Quality Management Team (reducing execution risk)
|Strategic relationship (reducing market risk)
|Product Rollout or Sales (reducing production risk)
A startup with a good idea, prototype and excellent management team with deep expertise in their field is given above average value for each factor. However, the startup has not generated any initial sales, thus increasing the production risk. With all of these factors considered, the total pre-money valuation for this startup is $1,075,000.
Note that $500,000 are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but assuredly also allowing the investor to put much lower values into each test, resulting in valuations well below that amount. There is no question that startup valuations must be kept at a low enough amount to allow for the extreme risk taken by the investor and to provide some opportunity for the investment to achieve a ten times increase in value over its life.
Obviously, this method also has its drawback as Berkus himself has recently stated, “The original matrix is too restrictive, and should be a suggestion rather than a rigid form.” Overall, Berkus method is a relatively easy, rugged and somewhat over-simplified model and should be used with modification to respond to altered circumstances or conditions.
The Scorecard Valuation, also known as the Bill Payne valuation method, is one of the most preferred methodologies used by angel investors. This method compares the startup (raising angel investment) to other funded startups changing the average valuation based on factors such as region, market and stage.
The first step is to determine the average pre-money valuation for pre-revenue startups. Angel groups tend to examine pre-money valuations across regions as a good baseline. Rivalry in different regions can differ from each other sometimes leaning to higher valuations so the data could be skewed at the upper range of the data set. AngelList as a great resource to explore startup valuation data from thousands of startups and you can browse by location, market, quarter, and founder background to get the average valuation of startups in your region.
The next step is to compare the startup to the perception of other startups within the same region using components such as:
- Strength of the Management Team (0–30%)
- Size of the Opportunity (0–25%)
- Product/Technology (0–15%)
- Competitive Environment (0–10%)
- Marketing/Sales Channels/Partnerships (0–10%)
- Need for Additional Investment (0–5%)
- Other (0–5%)
The ranking of these factors is highly personal, but the key emphasis besides scalability is on the team. Lastly, calculate the percentage weights. Below is an example using this method:
Here, we presume the team is strong (125% comparison) with a large market opportunity (150% comparison). However, the startup is playing in a very competitive environment (75%). By multiplying the total factor (1.0750) by the average pre-money valuation ($1.5M for instance), we arrive with a pre-money valuation of $1.6M for the target startup.
The Scorecard Valuation Method is certainly subjective, but given the risk undertaken by angel investors, this approach makes sense for investing in early stage startups. Understanding this method is also important for founders to know how to negotiate valuations with investors.
1.4. Risk Factor Summation Method
The Risk Factor Summation Method compares 12 elements of the target startup to what could be expected in a fundable and possibly profitable seed/startup using the same average pre-money valuation of pre-revenue startups in the area as the Scorecard method. The 12 elements are 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 and Potential lucrative exit.
Each element is assessed with a rating and money adjustment accordingly. Then, the money adjustment is added (or subtracted) to (or from) Average Industry Pre-Money Valuation to get the adjusted pre-money valuation.
For instance, the tech startup has a very strong management team, a well-developed prototype, with rising traction focusing on the local market in inception. The barriers to market entry are not high, however. The market is not highly regulated, and the geography for growth is politically stable. The startup has expanded a strong strategic partnership with a large corporate partner that may be a fit acquirer in three to five years.
The Average Industry Pre-Money Valuation is €1.5M
After calculation, we come up with the adjustment of €250,000
Pre-money valuation = €1.5M + €250,000 = €1.75M
The Risk Factor Summation Method is an improvement in both sophistication and granularity to the Berkus and Scorecard Method and is used mostly for pre-revenue, pre-money startups. However, it is still a bit arbitrary given that you have to pick a starting point and decide how much to add to each factor.
1.5. Valuation Based On Benchmarks Method
This method involves determining similar startups that have been evaluated in the recent past and in the same industry as to that of the subject company business. After selecting the relevant startups, the next step is to calculate key metrics by analyzing the peer group transactions. For early stage companies, the key metric can vary from business to business. It could be weekly/monthly active users (for SaaS startups), the number of patents filed (for Medtech/Biotech startups), etc.
For example, you are trying to evaluate your early stage SaaS company with 500 monthly active users (MAU). After researching the market, you have collected the information below:
|Monthly Active Users Multiple
The average MAU multiple of these 3 startups is (6x+5x+4.5x)/3 = 5.2x
With the multiple of 5.2x, your startup valuation can be calculated as:
Company Valuation = Average MAU multiple * MAU = 5.2 * 500 = $2.6M
This method can also be applied to calculate startup valuation over a period of time. For instance, a startup was accepted by an accelerator which invested $10K for 10%, which valued the company at $100K. At that time, the company had 500 users. After 6 months, the company’s user base has raised to 1500. As the number of users has tripled, the valuation of the company could be defined as $100K * 3 = $300K.
This valuation approach, arguably, may deliver value estimates that are close to what investors are willing to pay. Unfortunately, it can be very hard to find similar companies with valuation records published. Deal terms are often kept under wraps by early stage, unlisted companies – the ones that probably represent the closest comparisons.
1.6. Other Valuation Approaches
Beside 5 methods listed above, there are several other methods to evaluate businesses, including Cost-to-Duplicate, Valuation by Stage, Book Value.
- Cost-to-duplicate method involves looking at the hard assets of a startup and working out how much it would cost to replicate the same startup business somewhere else. The idea is that an investor wouldn’t invest more than it would cost to duplicate the business. For example, to find the cost-to-duplicate a software startup, you would look at the labour cost for programmers and the amount of programming time that has been used to design the software. The big problem with this method is that it doesn’t include the future potential of the startup or intangible assets like brand value, reputation or hotness of the market. Therefore, this method is often used as a ‘lowball’ estimate of company value.
- The development stage valuation approach is often used by angel investors and venture capital firms to quickly come up with a rough-and-ready range of company value. Such “rule of thumb” values are typically set by the investors, depending on the venture’s stage of commercial development. The further the company has progressed along the development pathway, the lower the company’s risk and the higher its value. A valuation-by-stage model might look something like this:
|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
|$2 million – $5 million
|Has strategic alliances or partners, or signs of a customer base
|$5 million and up
|Has clear signs of revenue growth and obvious pathway to profitability
- The Book Value Method is based solely on the net worth of the company. i.e. the tangible assets of the company. This doesn’t take into account any form of growth or revenue. This method is particularly irrelevant for startups as it is focused on the “tangible” value of the company, while most startups focus on intangible assets such as RD (for a biotech), user base and software development (for a Web startup)
2. Postponing valuation
Entrepreneurs are increasingly turning to convertible notes when raising an investment round. A convertible note is a short-term debt that converts into equity when triggered by a subsequent fundraise. Even though it seems a straightforward definition, much discourse and debate surrounds convertible notes.
- Simple structure and fewer complications
Startup financing rounds can quickly become complex and take up significant time and money. Convertible note financings tend to be faster, simpler, and cheaper than priced rounds. Benefits of this security type include delays valuation, simpler financing structure, better for taxes, potential lower risk of dilution for founders, retain control for the founder. Among these, perhaps the biggest advantage of convertible notes is the fact that it allows startups to raise investment without having to worry about a valuation. Early stage startups are usually pre-money and therefore it can be difficult to place a monetary value on what they do. Delaying valuation gives the startup time to figure out what metrics they will use to determine a price for later funding rounds, rather than having to figure it all out at a very early stage.
- Benefits to investors
First, there is the interest on the note, this can be accumulated and converted to shares so it does not have to be paid out in cash periodically. Secondly, a discount on the share price is offered when the convertible converts into shares. This means that when a note converts, the note holders get an automatic reward for the risk they took in the form of a discount on the shares. Finally, there is often a cap, which represents an agreed maximum pre-money valuation at conversion. This makes sure that when a startup is extremely successful, the investor will benefit additionally from that success. This creates a win-win situation for both startup and investor: the investor has a high chance of a positive return, while the start-up has a higher chance of securing the deal.
- Lack of Noteholder Control & Probability of losing money
Many startups fail before even making it to a Series A round, which means that investors lose all of their money — especially if there isn’t a maturity cap on the note. Moreover, noteholders have none of the other protections like board seats, protective provisions, pro-rata rights, registration rights, and other key investor rights typically used as part of the economic “package” which makes investing in early stage companies feasible.
- Drawbacks of convertible notes on startups
If future equity rounds are not completed, the convertible note will remain debt and thus require redemption, potentially pushing still-fragile companies into bankruptcy. In addition, it can negatively affect subsequent funding rounds and may include complicating clauses that negatively affect the startup in the future.
- Factors that affect the valuation
In any case, there are a number of common factors that will influence an investor’s decision. Some of these relate to the company itself, ranging from the quality of the management team, to product traction, to USP, to the desperation of the entrepreneur for funds. Others relate to the broader market: the size of comparable deals, the size of previous exits in the sector, an investor’s analysis of future trends and the likelihood of an exit (its potential size), the balance between demand and supply in the early-stage equities market, the ecosystem, etc. These factors can largely affect the company valuation depending on the taste of the investors. For example, considering 2 startups with similar characteristics, the one that originated from Silicon Valley will likely has a higher valuation than the other.
- Closing words
In conclusion, even though how to estimate the value of your startup before raising investment from investors is paramount, there are no precise valuations for early stage companies. In most cases, investors will calculate a number of valuation models and scenarios and take a weighted average of them (depending on the estimated fit of the model to the underlying business case), as a starting point or an instrument for negotiations. A deal will eventually happen for a certain price (market price) and companies will also refer to this price as their “market-valuation”.
Are you working on your company valuation right now? We’ll be glad to hear your challenges and help you define what would be the best model for your company – just get in touch!