How startup valuation works at the pre-revenue stage

At a very-early or pre-revenue stage, valuing a startup can be a tricky endeavour. After taking many things into consideration like management team, market trends, demand and the marketing risks, still what you get is just an estimation after all. There are quite a few formulas that are used by valuation companies to effectively value a pre-revenue startup.

Before jumping into the methods of valuation, let’s look at the factors which influence the valuation of a company:

1. Traction: It is one of the major factors that impact the valuation for the seed stage. It is quantitative proof of customer demand and demonstrates development and growth. It plays a huge role to convince investors to invest money in a company.
2. Reputation: Reputation of both the product and the founder matters to any investor. Both need to have a positive image in the market.
   
3. Prototype: Before planning to pitch to an investor, entrepreneurs must have the prototype ready. A prototype can be a game-changing addition to your pitch.
   
4. Pre-valuation Revenues: Investors love the words revenue and sales. If a product or service is already in the market and is generating revenue, it could sway the investor’s decision in the favour of the startup.
   
5. Distribution Channel: The founders have to be clear and careful about their distribution channels as it can have a direct impact on the valuation.
   
6. The industry: The valuation also depends on the sector that the startup is in. If it is a booming industry, the investors will be willing to pay a premium and it will increase the worth of the business.

There are various ways to calculate the value of a startup. But firstly, the founders will have to conduct a self-assessment that includes making a list of assets, identifying KPIs (key progress indicators) like success rate, user growth rate and referral rate. Then comes selecting a startup valuation model. And the final step is understanding the difference between pre and post-money valuations and making adjustments for reverse factoring.

Methods of Valuation

We discuss two main methods of valuation for pre-seed startups that are used worldwide.

1. Scorecard Method:

It is a popular startup valuation method used by angel investors. It’s also known as the Bill Payne valuation method. It was first developed in 2001 by American business angels, published in 2007 by the Kauffman Foundation and revised in 2011 by Bill Payne from Ohio TechAngels. The scorecard method compares the startup to others that are already funded.

First the average valuation for pre-revenue startups in that market space are determined. This allows the startups to find out how they stack up against others in the same category by assessing various factors.

The startup valuation company Equidam also uses this method to value pre-revenue startups. It gives the founders a Questionnaire. Based on their answers to the Questionnaire section on Equidam, the company is assigned a score that indicates whether it performs better or worse than comparable companies on the following 6 criteria –

Based on these scores and their weights, the valuation is adjusted upward or downward. The valuation by assessing these factors is a very subjective process, out of which the scalability and the team are paramount concerns.

2. Checklist Method

The Checklist Method by Dave Berkus, considers the intangible assets of a company. It is based on the tenet that intangible assets of early-stage companies are the foundation of their future success, just like the tangible ones. The checklist method considers the following

• Quality of the idea
• Whether there is a Prototype
• Quality of the team
• Existence of strategic relationships
• Whether product rollout has happened

This method is also used by Equidam to ascertain the pre-revenue startup valuations. The Checklist method assumes a fixed maximum valuation based on the region and assigns the company a score for each of the above 5 criteria, based on the answers to the “Questionnaire” section on Equidam. The weighted sum of the score of each criterion determines the pre-money valuation.

This method is only used for Seed/Angel Rounds. The developer of the method, Angel Investor Dave Berkus has participated in more than 140 early-stage deals. He proposed this method in 1996 and later extended it in 2016.

Apart from the above mentioned startup valuation models, there are some other models like the Berkus Method, Risk Factor Summation Method and the Cayenne Consulting Calculator. However, the Scorecard and Checklist methods of valuation are considered to be more trusted and accurate as well. Founders can experiment with several methods, and on the way, discover how to add more value to their startup.

For more extensive analysis and Market Intelligence reports feel free to approach us or visit our website: Venture Capital Market Intelligence Reports | VCBay.

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