- “How to evaluate an early stage startup?”;
- “How startup valuation works?”;
- “How to justify startup valuation for fundraising?”
... and many more similar questions asked by the majority of founders at the beginning of their fundraising journey. The underlying truth is that there is no unified and accepted analytical method of how venture and angel investors can determine a fair value of an early stage startup.
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How startup valuation works
Every student who studies in financial college knows how to calculate the value of the running business, using formulas based on sales traction, past years revenues and other metrics.
With later stage startups it works in a similar way. But at an early stage there is no revenue and other traction numbers allowing to come up with a reasonable estimation of startups’ value. The number of unknowns and uncertainties is very high, which obviously increases the risk factor and makes traditional valuation methods useless at this stage. Business plans and financial forecasts at the early stage startups are not justified by the real traction: they are just “promises” that founders sell to investors to demonstrate their potential. Therefore, investors can only assess the potential and the ability of the founding team to sell those promises.
And yes, it is very subjective and non-definitive, depending a lot on investors’ gut feeling and personal impression of the founders. However, there are still a few methods that are commonly used by many venture capitalists and financial institutions during due diligence, that help to come to some basic market numbers for the startup valuation on the pre-revenue stage.
InnMind’s investment analytical team observed the most common startup valuation models and wrapped them up to showcase various methods.
Most used startup valuation methods
1. Venture Capital Valuation Method
Most common stage: Seed, Series A
As a rule, the startup activity in the first years of operations are most likely unprofitable, therefore this method focuses on the predicted cost of a startup at the moment the investor exits the company. The key role in this method is played by 2 indicators: pre-money valuation (assessment of the company before receiving investments) and post-money valuation (assessment taking into account the investments received and the number of years after which the investor will exit the project).
The venture capital valuation methodology is simple yet descriptive and is based on the following equations:
ROI = terminal value/ post-money valuation;
Post-money valuation = terminal value / anticipated ROI
Terminal value: described as the selling price for the company at some point in the future and can be estimated by projecting a reasonable expectation for revenues in the year of sale and, based on those revenues, estimating earnings.
Anticipated ROI: the majority of VCs usually expect a 10-40x return on investment (as per industry norms for early-stage startups). Considering the following calculations logic, the pre-money valuation can be obtained in the following way (the numbers are taken as an example):
Post-money valuation: €35m (terminal value) / 20x (anticipated ROI) = €1.75m
Pre-money valuation: €1.75m – €300,000= €1.45m
2. Scorecard Valuation Methodology
Most common stage: Pre-Seed
The Scorecard Valuation method is based on the comparison of the target startup with similar or competitive companies on the market focused on multiple risk factors, and adjustment of the average valuation of recently funded companies in the industry. Such comparisons can only be made for startups of the same industry and stage of development to determine the pre-money (before fundraising) valuation.
While executing the assessment, there are multiple factors that should be weighted and given a score to obtain a full valuation. The score to each factor should be allocated in the range of -3 (worst) to +3 (best). The score should be then multiplied against the comparison factor range (see below), to give each section a weighting, then you sum up the total factor and multiply this against the average pre-money valuation for the startup’s industry.
"This is the kind of qualitative method I built back then at Growthbase (but we had a lot more variables and evaluation criteria). The disadvantage of this method is that it has no information about the startup itself (an investor may evaluate the team differently than another investor) or the value of the startup. Furthermore, this method can only be used for the so-called "copy cats", but not for the disruptive start-ups, which have never been seen before. Many of today's Unicorns, such as SpaceX, Palantir, 10X Genomics, Vir Biotechnology, Databricks, Rivian and others, would have failed at this evaluation," - commented Kirill Babich, Founder of Malamute Startups Agency, Entrepreneur, Venture Builder & Advisor
3. The Risk Factor Summation Method
Most common stage: Pre-Seed
The Risk Factor Summation Method, introduced by Ohio TechAngels, is the one that touches on a much broader set of risk factors that end up in determining the pre-money valuation of early stage startups. The method could be used as a first step in assessing the potential risks and must be surely combined with other VC valuation methodology. Most of the analytics in the industry outline the following factors upon which the valuation is performed:
Each risk (above) is assessed, as follows:
- +2 very positive for growing the company and executing a wonderful exit
- +1 positive
- 0 neutral
- -1 negative for growing the company and executing a wonderful exit
- -2 very negative
The average pre-money valuation of pre-revenue companies within the same market is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2).
4. Dave Berkus Valuation Method
Most common: Pre-Seed
Another way to evaluate early-stage startups is the so-called “Berkus Method”, created by a well-known investor Dave Berkus, who was known as one of the most active angel investors in the USA, having made and actively participated in over 180 technology investments.
“Years ago, confronted with the same conundrum, in the middle 1990’s I came up with a method of assessing the value of critical elements of a startup without having to analyze the projected financials, except to the extent that the investor believes in the potential of a company to reach over $20 million in revenues by the fifth year of business”, - that is how Dave Berkus describes how he came up with this startup valuation method.
If we take a look at his method, there are five aspects of the company that need to be assessed and assigned some value to each one:
As it is quite visible on the table above, this method accounts for some of the main risk factors that should be taken into consideration, whereby the user of this model can re-assess the value in each factor by changing the amount added across the board to reflect higher or lower prevailing average market valuations (i.e. have all the factors add up to something different than $2.5M).
Keep in mind: once a startup starts selling and making revenues, Berkus Valuation method, as well as others described above, are no longer applicable, because it will be a way more relevant to use actual revenues to project company value over time.
Watch an exclusive interview with Dave Berkus and Nelli Orlova, Founder of InnMind, to get more insights about Dave's experience as an angel investor and how he came up with this method.
5. Startups Comparable Method
Most common stage: Pre-Seed, Seed, MVP & First Sales
This method is based on comparison with the similar VC deals & valuations on the market.
For example: another startup, targeting your sector with the similar business model raised recently VC funding at valuation of €2 mln. You could use this benchmark to value your startup if it has certain similarities in stage, product, business model or target market...
As you can see, the assessment of a venture startup is a rather complicated task, since it depends on a number of barely accessible external factors and requires niche knowledge, significant time and energy resources. There are also many variations of the common valuation methods, the application of which depends on the presence of certain factors. Therefore, a combination of several startup valuation methods is something that will result in a more accurate and profound assessment.
During startup valuation at InnMind we don’t stick to any of these methods. We use the combination of them as some basic directory as a part of the overall scoring system.
To justify the fair valuation, we also consider many additional factors, like the background of founding team members, their previous experience and industry knowledge, business development traction up to date (even on an early stage), unfair advantages, etc.
Startup Valuation Online Calculator
To help founders InnMind team, in consultation with venture capital analysts and serial investors, designed the Startup Valuation Calculator, a simple and efficient tool to estimate the value of your startup business just in a few minutes.
How it works:
You can answer the questions about your current stage and traction and get an approximate estimation of your startup valuation based on the combination of valuation methods and the InnMind scoring model.
This is not a static exercise: you can play around different numbers and see how your valuation will change depending on the difference in your numbers. This should give you a better understanding of how you can justify the current valuation or what you can do already now to increase your startup valuation.
You don’t need to pay for a consultation or wait to receive the results in your mailbox: answer 10 questions online and get your startup valuation immediately - it’s that easy, fast and forever free!
How to justify and increase startup valuation
Remember: in the startup due-diligence process and investors’ decision making it is all about assessing startups’ traction and ability for execution. Therefore, even if you are at the pre-revenue stage, without working product and first sales, you still can do something to justify your startup valuation or even increase it.
Here are a few basic ideas and recommendations on what you can do without a marketing budget, large team, and even without a product to gain early traction and prove your execution skills:
- Before product launch make a waiting list of potential customers, who are willing to become early adopters and use your product;
- Make customer development, analyzing the main pains and needs of your future customers, as well as their willingness to solve them with your future product;
- For B2B products do your research & customer development, identify the most “warm” leads and sign MOUs or agree for pilot / PoC project once you have budget;
- If you don’t have a product or MVP and don’t have a team of developers, you can still find some recognized experts in the field who can be your advisors, or even agree that they can join your team after you raise seed investments. You can also get in touch with universities, labs or other organizations that can commit to participating in your product development on an “option” basis or on success fee;
- You can start marketing your startup/product in social media without a budget and use other free marketing channels to create brand awareness and attract potential early adopters.
There are many more things you can do on an early stage without a budget and a big team to demonstrate the execution capabilities and the potential of your startup for investors and to justify your valuation for fundraising. If you want to learn more about it and to discuss your particular case with InnMind experts, register your startup profile on InnMind for free and apply for a call with our team.
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