Valuing a startup is hard. And it’s probably as much an art as it is a science.
It’s hard because early stage companies are at the very beginning of their lifecycles.
I mean, how do you value a company with little to no revenues that makes promises of being the next Facebook?
Why valuing a startup is important
The reason this whole discussion even starts is that when a company raises money, it does so at a certain valuation — Company X raised $Y at $Z valuation.
If a company grows from scratch to be a $500M company, that’s great for early stage investors but it really matters what valuation the investors put their money in at.
In this example, there’s a big difference between putting money in at a $5M valuation vs. a $100M valuation.
First, get the lingo down
Professionals talk about “pre-” and “post-” money valuations.
- Pre-money is simply the value of the company at the start of the investment round – before any additional funds have been added.
- Post-money is the value of the startup after the infusion of funds.
For example: Startup A is valued at $500,000 pre-money and receives an additional $500,000 of funding during the round — then the post-money valuation of Startup A is $1,000,000 ($500k +$500k).
But as an investor, how do you know what the right valuation is?
More specifically, how do I know if I’m getting a good deal or a bad deal for my money?
5 stages for a startup: From funding to exit
Before you can answer this question, it’s important to understand the startup lifecycle. Because depending on where you enter as an investor, valuations can vary wildly.
According to Martin Zwilling, the founder and CEO of Startup Professionals, startups pass through five stages en route to exiting (if they make it that far).
The chart is a basic summary of his points:
If you are looking to this post for guidance, you’re most likely to find investment opportunities in the first two or three stages, making you either a certified member of the highly coveted 3 F’s club, or a new angel investor.
The question you now face is: How do I value a good investment when it comes my way?
…like it’s about to right now…
Today is your lucky day!
A friend mentions two investment opportunities: one is pre-revenue and the other has some traction. Both sound promising and you are hooked on investing in at least one of them.
How on earth do you value them?!
Conventional Pre-Revenue Best Practices
The views presented below are taken from highly successful Angels/VC Fund Managers/Academics who have spent the bulks of their working careers attempting to get a handle on valuations.
Comps (Comparables) method – Find a company that shares as many characteristics as possible with the one you are interested in and see what it sold for. A leader on this simple approach is Aswath Damordaran, a professor at NYU and renowned valuation guru.
In a lengthy paper, he writes that “… it seems logical that we should look at what others have paid for similar businesses in the recent past. That is effectively the foundation on which private transaction multiples are based.”
While the other 60-some pages discuss how these numbers need to be tweaked for a variety of factors, there is no doubt that the right Comps are king in mainstream pre-revenue valuation.
Hint: A start on how to find these Comps: Angelist just came out with a cool tool that the valuation for (mostly seed) rounds done on Angelist . Check it out here.
Team method– In my previous blog post I wrote about how to identify a talented startup team. I opened by quoting Carlos Eduardo, the co-manager and partner of Seedcamp (a leading micro-seed investment fund in Europe) who said, “A startup’s management team is its lifeblood… no amount of awesome ideas will ever overcome a fundamentally flawed management team.” (source)
More recently, I came across a blog post in the Wall Street Journal where interviewee Rick Heitzman (managing director of Firstmark Capital – one of the early funds to invest in Pinterest) really put the importance of good management in perspective when he said:
“If Jeff Bezos (the founder of Amazon.com Inc.) decides he’s leaving Amazon to start a new company, it wouldn’t matter if he had no idea what the company was going to be.”
Minimal risk and appropriate reward method – This one is tricky because at the pre-revenue stage, it is extremely difficult for entrepreneurs to minimize risk as there are so many unknown variables. Investors generally approach this issue by performing “due diligence.” James Altucher (currently a hedge fund manager for Formula Capital, but you might have heard of his successful startups Stockpickr or Reset Inc.) provides a concise and easy to follow guide on how any investor can do this.
WAIT! While research and forward looking estimates from experts are both great and valuable, at the end of the day, the results are pre-mature because the company is not yet producing Cash Flows!! Therefore, these numbers are still just educated guesses, educated, but still only our best guess.
There are many variables that can affect the research. Just to quickly list a few: The market size may be smaller than estimated, or a new competitor might seize a substantial portion of the market share. The competent and well reputed management team may clash, or legal issues might slow down the time to market which in turn could cause the business to be cash strapped or run out of money. For a comprehensive list of “startup killers”, click here.
While everyone dreams of finding a risk-free investment with guaranteed reward, no such investment exists…especially when it comes to early-stage companies.
So, sure, there are risks, but how do you deal with them?
Putting theory to practice: Making a formal scoresheet
Investors should only be interested in investment opportunities where as many risks as possible have been removed entirely, and those that remain are justifiably offset by tremendous opportunity – either in terms of more bang for their buck – a larger chunk of the pie — or better rights in future rounds.
If you were expecting a concrete guide to early stage valuation, this piece is, admittedly, very frustrating.
While you should be able to identify which factors are important when valuing a startup, the bottom-line is: you probably still can’t value one on your own.
One easy valuation anyone can do is the Scorecard Method.
4 steps to Scorecarding
- Assign each factor (a sample list is provided below) a score/weight that is appropriate for an average startup
- Go through each factor and determine where the startup ranks, (is it better or worse than average and by how much)
- Sum the total factor (promising startups total factor will be > 1, average ones = 1, and less than average ones will be <1)
- Multiply the total factor by the average valuation of comparable companies
Assigning weights to the score
This is how Bill Payne (an angel investor who been published in the USA Today and quoted in the New York Times) weights the valutaion factors in average company:
- Management Team 30%
- Opportunity Size 25%
- Product/Technology 15%
- Competitive Environment 10%
- Marketing/Sales/Partnerships 10%
- Need for additional Investment 5%
- Other Factors 5%
Although this method is far from a hard science, and the average weights provided are just one person’s view, at least it provides a ballpark valuation and a starting point.
Basic proposed strategy up to this point: Relevant comps + a good management team + low level of perceived risk **with appropriate reward for the risks that cannot be removed = higher valuation
The Other Side – There are many investors who believe focusing primarily on pre-money valuation is wasted.
Al Schneider, co-founder of Pasadena Angels, is among those at the forefront of this issue. He claims that “pre-money valuation is just one of many funding terms and conditions important to investors and companies, and not necessarily the most important one.”
For these investors, haggling over a valuation not only delays an investment, but, more importantly, it means that the investor missed the point. These contrarians argue that angel investments have two diametrically opposed outcomes: either you hit it big or it’s a big goose-egg (0). The old swing for the fences concept: Home-runs more than offset the strikeouts.
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