“Start-up valuation is more art than science” say most angel investors and venture capitalists. And it’s true, especially for pre-revenue start-ups. How much is your idea worth? How much are you worth as a founder? How do you convince investors about that?
Luckily, most of them want to invest as early as possible, because that’s where the big returns are. That’s why they’ve developed formulas and improved them over the last 30 years, even for pre-revenue start-ups. Sure, most of them are based on assumptions but this shouldn’t stop you from learning exactly how investors make those assumptions so you can make your own and be confident at your next investor meeting about how much your start-up is worth.
In this article, we’re going to show you exactly what formulas most investors use for pre-revenue start-ups, what they take into consideration, and how you can value your start-up or what to improve about your start-up so you can impress them and get the funding you need.
The 3 methods most investors use to value your pre-revenue start-up
There are about nine or ten start-up valuation formulas but most of them take into consideration financial metrics and other historical data. These three methods that you’re going to learn about in this article focus more on the start-up’s assets, the performance of similar start-ups, and risk factors in the market.
1. The Berkus Method
Invented in the 90s by American Venture Capitalist Dave Berkus, this is the easiest and most arbitrary start-up valuation formula on this list. It takes into account 5 core elements of your start-up which, according to the formula can be worth up to €500.000. The formula is based on the assumption that your start-up will reach a €20M valuation in the 5th year so now it can only have a maximum valuation of €2.5M to give investors a 10x return.
This method must only be used for pre-revenue start-ups as it doesn’t consider any financial metrics of risks. If any of those are known, you should use a more specific method.
The 5 core elements that bring value to any pre-revenue start-up, according to Dave Berkus are:
A valuable business model – Is there a business model? How sophisticated it is?
A prototype – Do you have an MVP? Have you tested? Is it scalable?
A quality management team – Is the team incomplete? How many members there are? What relevant experience do your team members have?
Strategic relationships in place – Have you built any strategic relationships? Are they big partners?
Initial sales – Are there any existing customers?
All these parameters are then given a value between €100.000 and €500.000, based on how well done they are and how much they can de-risk the investment. If your start-up would have all elements in place it would have a maximum valuation of €2.5 M. But since most pre-revenue start-ups don’t (and that’s no problem!) a realistic valuation would look something like this:
Download our free eBook if you want a detailed template of the Berkus method with 5-point graders for each element which will help you grade your start-up realistically, based on what the investors are analyzing about it. In 10 short pages, you’ll get three such detailed templates with step by step guides and other tips.
2. The Scorecard method
This second method is used by Angel capitalists and it was invented by a famous one – Bill Payne. It’s his approach to the Berkus method that he made more specific by considering the average valuation for start-ups similar to yours (industry and geography) It is also used only for pre-revenue start-ups, except those that need a lot of capital before achieving first revenues.
Before diving into the formula, you have to research thoroughly and define an average valuation for a start-up similar to yours (industry AND geography). You can look at lists like Crunchbase, Dealroom, or PitchBook and try to be as specific as possible. Don’t look for “tech start-ups” but instead look for “XTech start-ups in the CEE” or your own country.
Then the formula looks at 7 elements of your start-up, each having a different weight on the total valuation. You can play around with the weights but most investors use them like this:
Strength of the management team (30%)
Size of the opportunity (25%)
Product Technology (15%)
Competitive Environment (10%)
Sales/Marketing (10%)
Need for more financing (5%)
Other (5%)
For this example, let’s say you’ve found an average valuation of €1.5M. Next, you compare your start-up’s assets with the one you found on the list by using percentages. If you consider your team stronger, you can grade it as high as 125%. If it’s about the same, you add 100% and if it’s not strong enough, or if it doesn’t have all members you can go as low as 50%. Do the same for all elements.
Now you will multiply the weight of each element with the percent that you used to grade them and you will the adjusted weighting of each of your start-up’s assets, summing up to 1.06. If you multiply the sum with the average valuation of other similar start-ups you will get a pre-money valuation of your start-up of €1.59M.
3. Risk-factor summation method
This last method for valuing pre-revenue start-ups is a combination of the previous two which also considers the main risk factors associated with the investment in your start-up. Same as with the Scorecard method, you start by finding the average start-up valuation in your industry and region which will be adjusted on 12 main risk factors:
- Risk of the Management
- Stage of the Business
- Political Risk
- Supply chain or manufacturing risk
- Sales and marketing risk
- Capital raising risk
- Competition risk
- Risk of technology
- Risk of litigation
- International risk
- Risk of reputation
- Exit value risk
Then you rate these factors on a 5-point scale. Based on the rating, you will add or subtract money as follows:
Then, add the total sum to the average start-up valuation for your industry and there you go, that’s your pre-money valuation using the risk-factor summation method.
Conclusions
As you can see these methods are based mostly on assumptions. But if you do your research properly and you use more than one method, you will get a realistic valuation that is aligned with the investor’s expectation.
If you want to understand the methods better download the free eBook below. It has guidelines and scales that will help you better grade your start-up’s assets and risks factors based on what the investors are looking at. (not only your experience, for example, but the levels of your business model, its complexity, your team formation, the entry barriers in the market, the state of sales, and many others.)