Every entrepreneur knows that a common question on valuing startups is calculated by considering sales turnover, past earnings, and other indicators.
A process of valuing startups is done in the way described above. But early-stage startups have no income or other indicators to calculate their valuation. The number of unknowns is so large that it increases risks and makes traditional startup valuation methods inapplicable to early-stage startups.
Business plans and financial projections do not show an accurate picture: they just promise investors to demonstrate potential. Therefore, investors can only assess the potential and the team’s ability to realize it.
That’s why JetRuby discusses the steps that should be taken on how to evaluate a startup at an early stage in this article. The methods are described with examples explaining why a particular metric is so important.
Importance of valuing startups
Startup capital is comparable to a river in a complete desert. It is the only source of growth for the first few months to develop a powerful idea or prototype. If a startup doesn’t have capital, then it is most likely doomed to failure. The purpose of having your own money is essential as it will be continuing for at least 2 or 3 years if your startup will survive till that time. In most cases, you would need money for product prototype development, development team hiring, offices, marketing campaigns, and lots of other important tasks. So by evaluating your startup, you can already know how much funding one needs to raise. But the question remains: How will you do it?
Steps towards the proper valuing startups
1.1 Analyze your startup
The first thing to look at is the company’s balance sheet. Write down the assets the company has (fewer liabilities). Support can include the following items, but the list is not limited to:
- Proprietary software
- Cash receipts
Even if most of your assets do not represent real market value (except cash flow), this list will help you benchmark against other startups organized similarly.
1.2 Determine what your revenue will be made of
Many startups’ revenue level at the initial stage is primarily a market test, usually not enough to support a company’s growth intending to reach the market in the short term. So, in addition to revenue, identify key performance indicators for yourself to help you more intelligently formulate your valuing. This is where getting creative can be helpful. Here are some common KPIs:
- user growth rate (per month/per week)
- client performance index
- number of referrals
- daily stats
At this point, it’s important to note that if your asset list is empty or very limited, KPIs are also missing (e.g., you haven’t released anything yet), it would be better to go with an arbitrary assessment using, for example, Guy Kawasaki’s method.
1.3 Evaluate the team
A good team can go a long way to developing before it becomes a top-notch team of professionals. In other words, having experience and ability is highly valued by investors. The task of this analysis is not to take apart every individual employee “by the bone” but to honestly paint for yourself on paper the experience and advantages of this group of people as a cohesive and professionally working organism.
- What are the experiences of your team members?
- What have you created together in the past?
- Have you had experience launching and managing a startup company?
- Do you have experts in a particular field of expertise?
- Have you had a successful exit from a startup?
These are all examples of questions from those you will be negotiating your startup valuation – investors. Be prepared to present your team in the best possible light. Otherwise, such an element as “team” can bring a negative connotation to the bottom line.
2.0 Pick your methodology
Venture Capital Method
Often used for Seed, Series A-stages. Since a startup’s performance is usually unprofitable in the early years, the venture method focuses on the perceived value when the investor exits the company. Two metrics play a vital role in this method:
- Pre-money valuation or pre-investment process of valuing startups (a startup valuation of the company before the investment is received);
- Post-money or post-investment process of valuing startups (a startup evaluation that considers the investment received and the number of years after which the investor will leave the project).
The venture capital method is simple, and the formula is as follows:
ROI = final value/post-money valuation
Post-money = final value/expected ROI
The final value is the future selling price of the company. It can be estimated by assuming reasonable profits for the year of sales and calculating revenues based on those profits.
Expected ROI: most VC firms expect 10-40x ROI (according to industry norms for early-stage startups). Given the above calculation logic, a pre-money startup valuation can be obtained in the following way.
Post-money estimate = $41,3 million (final cost)/20x (expected ROI) = $20 million
Pre-money estimate: $20 million – $350,000 = €19,65 million
This method of valuing startups was developed for pre-seed startups by investor David Berkus. He was one of the most active angel investors in the US, who has made and participated in over 180 technology investments. In the Berkus method, five aspects of a company need to be evaluated and assigned values to them.
The values in this table are the same, but of course, they can be overestimated to show higher and lower average market valuations. Keep in mind: once a startup starts to make a profit, the Berkus method and the other methods described above cannot be applied to evaluate that startup.
Risk factor summation method
This method considers many more risk factors to determine a pre-investment assessment (pre-money) for early-stage startups. This method can be used as the first step in evaluating potential risks and should necessarily be used in conjunction with another method to evaluate startups. Most industry analysts identify the following factors as the basis for the assessment:
Each risk in the table is scored from +2 (very positive for company growth) to -2 (very negative for company growth).
The average pre-money score for pre-revenue stage companies in the same market is adjusted as follows: add $250000 for each positive score (+2 = +$500000) and subtract $250000 for each negative score.
Typically this method is used for startups in their pre-seed, seed, MVP, and first sales stage. This method’s essence is to compare the startup being evaluated to a similar startup that has already been considered earlier in an investment round. The difference in the value of both startups’ critical metrics, such as the number of users or customers, potential market size, risks, etc., is considered.
This method is based on comparing a startup to similar ventures and valuations in the market. You can use this method if the comparison objects have the same stage, similar product, business model, or target market.
Based on the above, valuing a startup is a complex task. Besides, there are many variations of generally accepted startup valuation methods, the application of which depends on the presence of certain factors. That is why it is recommended to use several startup valuation methods for a more accurate assessment.
The scoring method is based on comparisons with similar or competing companies and is often used for pre-seed stages. It focuses on multiple market factors and adjusting the average score for recently financed companies in the industry. Such comparisons can be made for startups in the same sector and development stage to determine a pre-money (pre-investment startup valuation).
When conducting the assessment, factors should be weighed and scored from -3 (worst) to +3 (best). The scores must then be multiplied by the comparison factor shown in the table below (column Range) so that each element has a value. Then we sum up the values obtained and multiply that sum by the industry’s average pre-money score.
This method’s disadvantage is the lack of information about the startup itself (since each investor evaluates the startup team differently) or its value. This method is not suitable for explosive startups that have never been seen before, like SpaceX, Palantir, 10X Genomics, Vir Biotechnology, Databricks, Rivian, and others.
How to enlarge your startup value?
Remember that during the pitching sessions, it all comes down to evaluating the startup’s development and ability to realize what you have in mind. So even if your startup is still without a working product and sales, you can already justify and directly answer the question on how to value a startup:
- Before launching your product, create a list of potential customers who want to be the first users of your product;
- Engage in customer development by analyzing the significant pains and needs of your future customers and their willingness to address them with your product;
- For B2B products, research and develop customers, identify your warmest leads and sign agreements with them to implement a pilot project;
- If you don’t have a product or MVP and no development team, you can find recognized experts who will be your advisors or even agree to join the team after you get the investment;
- You can reach out to universities, labs, and other organizations that will participate in product development on an “option” basis or for a success fee;
- You can launch social media marketing without a budget and use other free channels to create brand awareness and attract your first followers.
You can do many other things early on without a budget and a large team to demonstrate the feasibility and potential of a startup. In our experience, we tend to structurize and break down the development plan, identifying hidden industry milestones and prioritizing functional tasks that one needs to complete for an MVP. All of that is neatly packed in our technological development flow, starting with the Product Development Strategy Session.
This is the first step towards the concrete and detailed business plan, where our experts will analyze your product potential. Along with that, we will produce a ballpark estimate on your current development direction, adjust it, provide some core guidance along with the commercial offer for the subsequent development step. If you are interested in it, leave your brief project details, and we’ll contact you within 24 hours.