66. 💵 Pre-revenue startup funding: valuations & venture capital

If you're thinking about raising funds for your startup, you might be asking what your company worth right now, the pre-money valuation? I'm going to pull back the curtain and explain to you how investors look at valuing your startup.

Mature or public companies are often valued based on their revenues or earnings. You'll often see "this company is valued at twenty times earnings." But that doesn't work when you're an early-stage startup with little to no revenue. In fact, you're probably losing money, so your earnings are negative. How can you calculate what your company is worth?

There are a few common valuation methodologies. I'm going to walk through each of those before sharing the secret behind what's really going on.

Startup valuation factors beyond revenue

In the absence of revenue or earnings, investors look at several other factors. One of the most important is traction. How are you doing at getting interest from customers and creating a waiting list?

The next factor is your team. Who is working in the company do they have the experience and skill sets that will allow them to successfully execute on the plan?

How mature is your solution? Do you just have a wireframe or prototype? Have you built your MVP? Have you completed the full 1.0 version of your product? The more finished it is, the less risk for the investor, and the higher your valuation will be.

They can also look at the financials around your business. How big is the opportunity? What is the total addressable market? What might you be worth at exit if you hit a home run?

The Berkus Method

The first formal methodology is called the Berkus Method. It involved assigning a value between $0 and $500,000 to each of five factors. That generates a total valuation between $0 and $2.5 million. If the company is exceptional in some category, it would get the full $500 thousand. If it is weak there it might receive only $250 or $100 thousand.

The five factors are:

·       Is it a sound idea?

·       Do you have at least a working prototype?

·       Do you have a high-quality management team?

·       Do you have strategic relationships/channel partners?

·       How are you doing with product rollout and initial sales?

One of the problems with the Berkus method is that $2.5 million is a low valuation for any startup with meaningful early sales. In practice, I don’t see it used very often, but you might encounter it with some investors.

 The Scorecard Method

Another valuation methodology is called the Scorecard Method. To compute your valuation you compare your business to some other similar company that recently received investment. If investors valued this other company at $3 million, your valuation would be higher or lower depending on your relative achievements over seven categories. Because they are not equally important, each category is assigned a specific weight in the overall score.

·       30% Management team

·       25% Size of opportunity

·       15% Product/Technology

·       10% Competitive environment

·       10% Marketing/Channels/Partners

·        5% Need for additional investment

·        5% Other

You might have a better management team but a highly competitive environment. That could give you a score of 1.25 for your team and 0.75 for the competitive environment.

You multiply each of the scores by the percentage weight and add them up. The result represents how much better, or worse, your company is than the reference business.

If that total was 1.5, then your valuation would be 1.5 times $3 million, which is $4.5 million.

The Venture Capital Method

Next is the Venture Capital Method. Angels rarely use it, but it is popular with many institutional investors. This methodology sets the valuation such that they can achieve some desired rate of return. They look at the size of your exit if you are extremely successful, discount that by the amount of dilution they're likely to experience over the next rounds, and then work backwards to find the valuation that gives them the returns they need. Typically, they want 20 to 50 times their investment.

·       Anticipated exit  / target ROI = post-money valuation

·       $100M expected exit / 20x return = $5m post

·       $5m post - $1m investment = $4m pre

·       $4m pre * 50% expected dilution = $2m pre

Interestingly, this methodology ignores the current state of your business. The VC only focus on the returns from outstanding outcomes. Anything else is considered a failure.

Sometimes you'll see people using a method called Risk Factor Summation. It’s a hybrid of the Berkus and Scorecard methods. There are other less common methodologies in use, but they are generally small variations on these basic tools.

Now, before I get to the secret valuation methodology, I'd like to ask you for a favor, please join Feel the Boot and sign up for our mailing list. It’s the best way for me to stay in touch with you. I also send out a link to join my regular office hours for free one-on-one coaching.

The Real Method

The dirty secret is: few Angels actually use any of these valuation methodologies. We tend to go by gut and instinct based on our experience. We see huge numbers of deals and valuations. We a feel for the typical valuations for companies in your space, at your stage with similar teams.

I can glance at a deck, have a quick conversation with the founder, check the direction of the wind, and give you a number.  And that seems to be the way most of the people I know do it too.

If you challenge us on the number, we might use one of these methodologies to explain our offer, but we are just justifying the answer we already gave you.  We tend to use these methodologies like a drunk uses a lamppost, more for support than for illumination.

Whatever arguments people make, your company's valuation is what you can get people to pay for it. There's always an aspect of negotiation ending up with some compromise value.

Sometimes you'll be able to get an extremely high valuation. Possibly much more than other investors would consider reasonable. While that might feel like a big win, it can come back to bite you later. Excessive valuations make incentive stock options less valuable to your employees and might prevent you from raising money in the future without a punishing down-round. Shoot for a valuation that is generous but realistic.

Please share your experiences negotiating startup valuations in the comments!