One of the challenges that every entrepreneur faces is the issue of valuation. In other areas of business, valuation is typically tied to revenue, past performance, assets, and/or discounts of future cash flows. Since pre-revenue startups lack these things, the question becomes: how do you value a pre-revenue company?
There is no definitive answer here, but there are frameworks for thinking. While they may vary substantially from one investor to the next, the one that we have seen most frequently from angel investors is the following is a variation of “Relative Valuation”.
“Relative Valuation” is commonly used as a check/balance in various M&A activities, and the principle is quite simple: how do you stack up against other comparables in your space? In the start-up space, comparables fall into two categories: competitors and start-ups in general. In practice, investors are going to look at other deals similar to yours, and are likely to know the valuation at which these companies were invested. By looking at several of these deals, they can build an acceptable range for valuations in the start-up space. Deals that fall outside this range are met with increased scrutiny, and are less likely to close investment at their proposed valuation.
While the acceptable range is by no means exact, there are pretty clear points where investors tend to become disinterested in a company. Just a year ago, $1.5M to $6M post-money was regarded as perfectly reasonable; now, by contrast, the range is closer to $1M to $3M post-money. This is due to a number of factors, including uncertainty in projecting the future, a lack of viable exit scenarios, and the simple fact that investment is a ‘buyer’s market’. What this means is that a startup without revenue is unlikely to get by with a pre-money valuation of more than $3 million, and even $3 million valuations are more the exception than the rule.
The next question, then, is how an investor determines where a startup belongs on this scale. The best way to envision this, I think, is as a system of checkboxes. Some examples: Does the company have a prototype? Does the company have patents? Does the entrepreneur have previous successful exits? Is there a large market opportunity? Is this company acquirable? The list goes on in this fashion, and is focused mostly on sustainable competitive advantages, market size, intellectual property, management team experience, and exit potential. As I’m sure you’ve guessed, the more checks you are able to accrue, the more justifiable a higher valuation becomes.
As the sophistication of an investor increases, the number and complexity of the checkboxes typically does as well. If you are going to go after some of the more sophisticated capital that’s out there, then that means that you have to have everything pretty nailed down, so that you have the ability to provide compelling answers to in-depth questions. If you are still just getting started, on the other hand, then don’t plan on getting any of that institutional capital. Stick to friends, family, and individual investors who are connected to your project until your company can stand up to a deeper level of scrutiny.
As oversimplified as this explanation is, it’s a good framework to understand some basic drivers in the valuation process. Applying the same type of systematic approach to the company will help you to understand the gaps in your business model, so that you can identify and address critical risks before pitching to investors.
