Recently, I wrote about how do you value your start-up Part 1. In this blogpost I wrote about 5 different methods how to valuate your Start-up.
Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies.
I’ll be sharing three pre-money valuation methods often used by investors. Below, we’ll review how investors determine pre-money valuations by applying the following three pre-revenue methods: Scorecard Valuation Method, Venture Capital Method & Berkus Method.
1. Scorecard Valuation Method which adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company
2. Venture Capital Method
3. Berkus Method which attributes a range of Euro values to the progress startup entrepreneurs has made in their commercialization activities.
Scorecard: for early-stage companies that have limited revenues and other quantitative metrics
The Scorecard method requires comparable early-stage companies in which investors have invested and on which other investors have put an valuation. To apply this method, you start with a median valuation from a group of recent deals in your locality or investment ecosystem, for a particular industry and region. A series of critical factors for the company that you are valuing are then evaluated and the weighting or importance of each is estimated. The sum of the weightings should equal 100%. If you ascribe a factor of 1.3 to the management team, for example, you are assessing the management team as being 30% stronger than the average team you have experienced. For example:
- 1.30 for a strong management team x weighting 25% = +0.33
- 1.25 for a huge, compelling opportunity x weighting 20% = +0.25
- 1.05 for an adequate prototype x weighting 20% = +0.21
- 1.10 for strong sales and marketing channel x weighting 15% = +0.17
- 1.10 for lack of credible competitors x weighting 10% = +0.11
- 1.10 for good relationships in the supply chain x weighting 5% = +0.06
- 1.00 for connectedness with advisors and other investors x weighting 5% = +0.05
Other factors may feature. The sum of those factors gives you a multiple which you apply to the median valuation. In our example, we arrive at a factor of 1.18x and if the median valuation was €1 mil., you could estimate the valuation of the subject company to be €1.18 million.
Venture Capital (VC) Method;
The VC Method, first made popular by Harvard Business School Professor Bill Sahlman, works its way to pre-money valuation after first determining the post-money valuation using industry metrics. By applying the VC Method to solve for the pre-money valuation of a startup it’s important to know the following equations:
Post-money valuation = Terminal value ÷ Expected Return on Investment
Pre-money valuation = Post-money valuation — Investment
We will use these formulas to ultimately work out the pre-money valuation, but first we need to find the terminal value. The terminal value is the anticipated value of an asset on a certain date in the future. The typical projection period is between four to seven years. Due to the time value of money the terminal value must be translated into present value to be meaningful. For the purposes of this example, we’ll be solving for the pre-money valuation by using two separate exit multiple approaches.
By researching the average sales of established companies within the same industry (at the end of the projection period) and multiplying the figure by a multiple of two, we can calculate the terminal value. For example, let’s assume your startup is raising €500K and expecting to be generating €20M when you sell the company in five years.
Terminal Value = €20M x 2 = €40M
The statistical fail rate for angel investments is over 50% so investors typically target 10x-30x ROI on each individual investment. To be conventional, we’ll set the anticipated ROI at 20x for the pre-revenue startup. Knowing you’re raising €500K, we’ll then work the math backwards to calculate the pre-money valuation.
Post-money valuation = €40M ÷ 20x = €2M
Pre-money valuation = €2M — €500K = €1.5M
The Price/Earnings ratios ( P/E ratio) could also be used as the multiple for valuing your pre-revenue startup. If your expected after-tax earnings are 15% upon exit in five years, this leaves you with €3M (€20M x 15%). Then you need to multiply this value by the P/E ratio which is backed by industry benchmarks of similar public startups. Let’s say the P/E ratio is 15x with the same expected ROI of 20x.
Terminal Value = €3M x 15x = €45M
Post-money valuation = €45M ÷ 20x =€2.25M
Pre-money valuation = €2.25M — €500K = €1.75M
Investors typically calculate both multiples and take the average of the two. Therefore, the pre-money valuation of your startup is roughly €1.625M. This is a very simple introduction for entrepreneurs to the VC Method as I did not account for multiple rounds of investment and anticipated dilution. If future rounds of funding are expected to create dilution of 50%, then reduce the current pre-money valuation by 50% to €812,500.
The valuation will also be reflective of the type of investor you can get on board
By using the anticipated value and ROI, we’ve worked our way backwards to a pre-money valuation for your pre-revenue startup. The VC Method is definitely more quantitative than the Scorecard Valuation Method. Inputs will vary across verticals and industries so I recommend experimenting with VCmethod.com spreadsheets to achieve what you’d believe to be optimal outputs for you and your investor(s). The VC Method is not only a good route to determine pre-money valuation, but also for systematic planning of future rounds of investment.
The Berkus Method:
“Pre-revenue, I do not trust projections, even discounted projections.” — Dave Berkus
How to estimate the value of your startup before raising investment from angel investors is paramount. It’s also important to understand your investors interest such as the size of the exit they are striving for. There is no universal truth when it comes to valuations — Be flexible. The Berkus Method will not be relevant once your startup starts generating revenue, but it can certainly provide a simple approach to determining your value while in negotiations with investors.
The Berkus Method was developed in the 1990’s and Berkus has recently stated, “The original matrix is too restrictive, and should be a suggestion rather than a rigid form.” The method should allow for higher maximum value on elements not listed in the matrix.
According to super angel investor, Dave Berkus himself, the Berkus Method, “assigns a number, a financial valuation, to each major element of risk faced by all young companies — after crediting the entrepreneur some basic value for the quality and potential of the idea itself.”
The Berkus Method uses both qualitative and quantitative factors to calculate a valuation based on five elements:
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
But the Berkus Method doesn’t stop with just qualitative drivers — you must assign monetary value to each. In particular, up to €500K. €500K is the maximum value that can be earned in each category, giving the opportunity for a pre-money valuation of up to €2M-€2.5M.
Berkus sets the hurdle number at €20M (in fifth year in business) to provide some opportunity for the investment to achieve a ten-times increase in value over its life.” Below is an assessment of a fictitious pre-revenue startup illustrating the general rules of the Berkus Method:
With €500K as the maximum value per category, I assigned the greatest value to the quality of the management team (€350K) because the founders have deep domain expertise in their respective field.
The quality team reduces execution risk. (After all, ideas are cheap, but execution is everything.) With so much risk undertaken by the investor, the start-ups management team must be fully capable of achieving long term success.
The startups prototype (€300K) is sound, having minimal technology risk. Ultimately, I gave the startup a pre-money valuation of approximately €1.2M.
To estimate your own startups value, download a copy of this Berkus Spreadsheet here.
Other deal breakers
This is the second part of a 3-part series on Valuing a Start-Up Company. This second part is all about pre-money valuation and which 3 methods you are able to use to value your company.
The third part contemplates valuation of a blended-value start-up, in other words, a company that has a social mission embedded in their business model, aims to deliver positive social impact or change, or tracks itself based on a triple bottom line People, Planet & Profit this will appear in two weeks time.
If you would like to be updated with more valuable information please download our free E-book here.
The more valuation models you use the more confident you can be that you have valued the business correctly.
Good luck with your valuations!
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Jeroen van der Heide Co-founder & Ecopreneur
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