If the “valuation question” from investors makes you shudder, welcome to the club. For early-stage companies with little-to-no track records of operational data, the valuation process can be akin to a guessing game.
Ultimately, your pre-money valuation is any number you and investors agree upon. The nuance is the earlier the stage, the more arbitrary the process of valuing your startup becomes.
What factors do you base your pre-revenue or early post-revenue valuation on? How do you calculate it with little operational data at hand? And how do you negotiate the best possible deal? Having gone through this many times with our clients, we’ll walk you through the answers and explain how to value your startup for venture capital investors (and yourself).
The key components of a startup’s valuation
Ultimately, the value of your company at the early stages boils down to earning points that prove you’re less of a risk and more of a lucrative investment opportunity. These points can be divided into internal (company-specific) factors and external factors.
The value of each factor will depend on your stage and investor preferences. We had stories when a pre-revenue startup received great valuation thanks to its stellar team and a beautiful pitch deck we put together for them.
While most of these factors don’t exhibit factual financial value like, say, EBITDA or revenue, they all are used as a foundation to calculate the potential to bring returns (on how in a minute). With each factor added, the risk that your venture will flop and blow investor money goes down — and your valuation goes up. This helps investors arrive at the valuation of pre-revenue companies.
For example, suppose two pre-revenue companies have the same characteristics (trendy market, strong team, unique offering), only one is just building an MVP, and the other has already achieved product-market fit. In that case, the latter will be valued higher.
We’ve met founders who claimed to be worth $30M while having a two-people team, a half-baked GTM strategy, and no MVP on the horizon. Besides being a generally bad deal for investors, it also deemed the founders as out-of-touch. After being repeatedly turned down, they wisely reconsidered their appetites and raised.
Now, before we get to the how-to in valuing your early company, let’s first understand how not to and why.
How not to value an early-stage startup: No-go methods
Discounted cash flow method
The discounted cash flow (DCF) valuation method involves forecasting cash flows for the future 10 years (plus “extra” cash flows after that period) and discounting them to their present value using an appropriate discount rate. It uses assumptions about your future growth rate, market share, gross margins, etc., to arrive at a valuation range.
However, there are a few problems with this method when used to value early companies:
- It is highly speculative. Basing your valuation on assumptions about future cash flows without having any cash flow history is, ahem, a bit unreliable. Depending on the discount factor you choose to rely on, you can arrive at a $1M or $500M valuation — and it’s pre-product. Just tweak a few parameters, and you jump from one to a hundred of million in projected revenues.
- The horizon of the projections is too long. On average, VCs hold on to shares for 3-7 years. Your financial projections based on the timeframe beyond that (assuming they aren’t complete BS like they usually are) will be useless for them anyway if they plan to pull out earlier.
Plus, this model is based on a very optimistic assumption that your company will exist for over ten years, which may not be the case. Even if it will, trying to predict your operating model ten years down the line, without any cashflow history, in yet unknown market conditions is a stab in the dark.
Can we still apply this method if the client and investors request it? Yes, and we do it now and again. Do we think it’s a suitable valuation method for early companies? No.
The Berkus valuation method is a widely-recommended technique that assigns a monetary value to five non-core factors:
- Quality team
- Sound idea
- Strategic relationships
- Market size or Opportunity
Each factor is then added together to arrive at a final valuation.
Now, there are a few flaws to this method which, in our opinion, make it utterly ineffective:
1. It’s vastly arbitrary. The value of each factor is subjective and can vary drastically from investor to investor. As a result, the final startup valuation will almost always be biased.
2. It doesn’t work for all types of startups. For example, startups in super-regulated industries, like healthcare or energy, may have different valuation metrics than those in tech.
3. It ignores dilution. The Berkus method only considers the pre-money valuation, so investors don’t know what dilution % they can expect in the future and, therefore, what ownership stake to claim now.
With this in mind, let’s see how one should value an early company.
Best pre-revenue and post-revenue startup valuation methods
We use the following methods to help our clients come up with approximate valuation numbers to start negotiating with investors. Each method has its advantages and flaws, so pick those that suit your stage, the data at hand, and the business case.
Venture Capital method
This method was invented by Venture Capitalists and is widely used by them and angel investors. It boils down to projecting your future exit valuation and the expected returns for investors when you reach that value and then working your way back to derive your present valuation.
Here’s a made-up example:
A SaaS company is asking for $2M. For investors to deem this company worth investing in, it must promise to bring them $20M when they exit in, say, five years. To calculate the feasibility of delivering this ROI, investors look at your five-year projected revenues and apply a median multiple based on comps.
Let’s assume that the projected revenues for the fifth year composed $20M — pretty achievable for a SaaS startup — with a median multiple of 8x.
Then, we simply discount the exit value at the desired rate of return to extract the present valuation:
Multiples valuation method
Note: this method works for pre- and post-revenue companies that already have a product and product-related traction data, e.g., users, revenue, sales, etc., to apply multiples to.
A multiples valuation method compares your metrics like EBITDA, revenue, sales, net income, or users to similar metrics of other companies when they were sold (transactional multiples) or are publicly traded (trading multiples).
If your company already has some operational history, to arrive at a reasonable valuation sum using this method, you need to:
- Find transactional data of similar companies at the relatively early stages
- Use the right multiplicators
The first step is straightforward — you need to look up companies similar to yours and examine their recent M&A activities. We recommend using transactional multiples of “younger” companies, as they, unlike most IPOs trading multiples, will be more applicable to early-stage startups.
What multiples should you use as a reference point? The answer will depend on your business model, current results, and the comparable company’s multiples. To understand the principle, let’s first look at how not to choose your multiplicator.
Let’s assume you’ve generated $500k in revenue and decided to use it as your multiplicator. A similar company you use as a reference was recently sold for $30 million and had an annual revenue of $10 million. The revenue multiple you would use will be 3x ($30 million / $10 million).
Do you see a problem here? Such a valuation puts your post-revenue company in one line with pre-product companies that aim to raise $600k at most, which is likely not your case.
To avoid undervaluing your company like that, pick multiplicators that do your company justice. Are you a post-revenue startup with tangible revenues? If the transactional multiples look good, use revenue. Have low revenue and negative EBITDA but an accumulated pipeline of users, like Flo or WhatsApp did? Go for the user data.
Case in point with users as a multiplicator. A company similar to yours was recently bought for $60M (transactional multiple) and, at the time, had 100M users (operational multiple). Thus, if you have 10M users now, you are valued at $6M.
5 ways to negotiate a better valuation for your startup
Before we get to the meat of the section, we’ll answer the most common question: Should I aim for the highest valuation I can possibly get?
The answer is no. You should aim to get the highest reasonable valuation you can get and avoid overinflated valuations, as they will likely backfire on you and your investors. High valuations come with high milestones to achieve, and missing those milestones will cause your post-money valuation to tumble.
As a result, you’ll get a flat or down round and higher dilution for your current shareholders, potentially leading to a series of disagreements within the board. In other words, overvalued startups usually fail to deliver on their promises and pay a high price for that. Trust us, you don’t want this fate.
With this out of the way, here is how to negotiate a better valuation:
Promise stellar returns
VCs take on formidable risks only when the expected payout is equally formidable. A promise of 10x returns is a prerequisite for your deal to go through. You may have flawless metrics and reliable growth traction, but if your ambitions look “meh,” you won’t raise a dime. More so, you will be branded as “unambitious” in the inner VC circles, which is worse than being overconfident or delusional.
Review your future milestones and financial projections and ensure they reflect the promise of 10x returns. If you see that, no matter how you tweak your financials, you can’t get there, it might be time to rethink your business model and overall strategy.
Prove that your plan is highly likely to work by highlighting positive traction and providing a well-thought-out strategy. A strong team, strategic partnerships, organic traffic, social media communities, a user pipeline, and good unit economics — such factors help prove that your concept will succeed, which will increase your valuation.
The same goes for your reasoning. Show investors that you know your product’s strengths and weaknesses and how to use both to get to your ambitious milestones.
Find more interested investors
We know the fundraising environment is tough at the moment, and sometimes the first offer you get might be the one you are happy to accept. But let’s be real: your startup’s value grows with the number of offers on your table. And this number depends on how well you can present your business — both in your pitch deck and your delivery.
Do your best in this department to find at least a few interested investors so you don’t become desperate and have to settle for the first offer that comes your way.
Don’t throw a number
If you spill out a number immediately, you risk selling yourself short or lacking flexibility and missing out on the opportunity altogether. Instead, you should have a range based on your calculations and the information you’ve collected from your previous investor conversations or research.
Speak to as many investors as possible. Ask them how they approach valuations, what “math” they use, and why. Gather this information to know what methods and drivers to use to justify your valuation rationale. This makes you well-informed and able to justify your number with ease.
What is a pre-revenue company?
Pre-revenue company is typically a company in a Pre-Seed or Seed stage that is focused on developing its product or finding a PMF and has negative EBITDA and no substantial revenues. It’s a high-risk startup with its valuation heavily depending on factors like the team, the market’s and idea’s potential, the quality of the business model, etc.
Pre-money vs. post-money valuation: what’s the difference?
The difference is about the timing of the valuation. Pre-money valuation is the value of your company before you raise money. For example, when investors ask about your valuation during your pitch, they ask about your current pre-money valuation, aka how much you cost before receiving their money. The post-money valuation is your projected worth after you receive the most recent funding. It shows a company’s ability to scale and bring returns for investors and considers their share when calculated.