Is it necessary for both investors and owners to do startup valuations? How would investors and owners determine the worth of a startup if it has no revenue? You must have these kinds of questions. Let’s take a closer look at how to value a business before it generates money.
Investors and owners are both required to find the value of a company when it has no income for their better opportunities.
Why do investors and owners both need to evaluate the Pre Revenue StartUps?
In order to attract excellent funding, all startups must assess their worth. When a company goes for fundraising rounds or going to be acquired then investors need to evaluate a company to ensure they obtain a balanced picture of it and can get a good deal after investing. They receive equity ownership in a firm in exchange/return. The investor will calculate the percentage of stock they will get for their funds invested by valuing the firm. Owners must evaluate the business to identify potential possibilities and future growth plans, as well as ensure that they do not undervalue the business by guessing as it can create huge losses.
Traditional methods of valuation, such as predictions, financial statements, and quantitative analysis, are used to value a firm, however, they will not work for pre revenue companies.
All of the startups start with zero revenue. It’s difficult to put a value on a startup that doesn’t have any revenue yet. So, let’s discuss how non-traditional ways of valuation worked for a company with no revenue.
Methods used for Pre Revenue Startup Valuation
There are various methods to derive the value of the startups that have no income:
- Berkus Method – This is based on estimation. It’s done by the assumption that the company will generate $20 million in sales by the fifth year. To see whether this is achievable, they will allocate a sum of up to $5,00,000 to various lines inside the factors of the organization.
For Example, $5,000,000 assign in different factors of organization: Business Idea – $5,00,000, Management Team – $5,00,000, Strategic Relationships – $5,00,000, – Completed Product – $5,00,000, and Technology – $5,00,000. So, the total pre revenue startups value $2.5 million. The investor will assess if all of these lines can be combined to bring the company’s revenue over $20 million in five years.
- Scorecard Method – This method compares and creates an estimate from other firms in the same sector and same location. If a startup is similar to another firm that was just valued at $2 million, then startup value should be $2 million as well. The startup’s worth is then changed depending on the need for further funding.
For Example, Scoring the six success factors based on pre-percentage weighting (investor’s preference) such as:
Management Team – 30%, Opportunity – 25%, Competitive Environment – 15%, Technology – 10%, Sales – 10%, Investment – 5%, Other – 5%. These criteria ranked in a subjective manner.
- Chicago Method – These methods focus on predicted cash flows. It considers the profit that may be made by making the investments in the right places. The best-case, mid-case, and worst-case scenarios are all considered in the financial predictions.
For Example, XYZ Ltd. is to invest $500,000 in a small company and the three scenarios can come. First is the best-case scenario, where investors have 50% chance of a high-profit margin. The second is the mid-case scenario, where investors have 30% chances of profits, and the Third is the worst-case scenario, where investors have 20% chances and lose their investment than to get a weighted sum average, all of the probabilities are put together.
- Venture Capital Method – This method uses forecasted five years of revenue, then awards trading multiple net profits based on the industry benchmarks/standards, and finally subtracts the desired investor’s return. So, it’s a two-step process to calculate pre revenue valuation. 1. Calculate the terminal value of the business and 2. Track expected ROI and investment amount.
For Example, A XYZ Ltd. projects $5M in 5 years, profit margin of 10%, and P/E ratio is 15, and the investor wants ROI of 5x on his investment of $0.5M. So first we calculate the terminal value and then pre revenue valuation.
Terminal Value = projected revenue * profit margin * P/E
Terminal Value = $5M*10%*15 = $7.5M Then,
Pre Revenue Valuation = Terminal Value/ROI – Investment amount
Pre Revenue Valuation = $7.5M/5 – $0.5M = $1M
- Risk Factor Summation – This method is a combination ofthe Berkus method and the Scorecard method. This method analyses twelve risk factors and subtracts or adds the monetary value for each element on a scale ranging from very low to very high risk. The risk rationale are -2 (very negative) = subtract $500,000, -1 (negative) = subtract 250,000 , 0 (neutral) = add/subtract nothing , +1 (positive) = add $250,000 , +2 (very positive) = add $500,000.
For Example, A XYZ Ltd. assumes the average pre-money valuation in the region is $1M, then risk analyze by adjusting to pre-money valuation as per risk rationale in different risk factors of organizations and sum-up of the adjustment results came with $5M, then add the adjustments value with an average pre-money valuation in the region. So, the pre-money valuation would be $6M.
- Book Value Method – The entire value of shares held by shareholders after the share price has been divided into many equal pieces is referred to as book value. Book value of startup = Total Assets – Total Liabilities.
For Example, The total asset of a startup is $5M and the total liabilities is $3M.
So, Book value of startup = $5M-$3M = $2M.
- Cost-to-Duplicate – This approach calculates the cost of relaunching the business somewhere, less any intangible assets such as company brand or goodwill. Add the fair market value of the company’s tangible assets together and also include charges for research & development, product prototypes, and patents. Also, it doesn’t consider the whole value of a company, particularly if it is generating revenue.
- Comparable Transactions Method – This method is similar to the market approach and based on the precedent. In this method, find revenue multiples for similar companies in a company industry.
For Example, Normally SaaS companies generate 5x to 7x the prior year’s net sales. ABC Ltd. is a SaaS company and doesn’t have proprietary technologies like other SaaS companies in the market then, they might utilize a smaller multiplier, such as 5x (or lower).
As a startup, every owner and founder needs a valuation for future benefits. It helps in long-term planning for investors and owners as well. There is no single strategy for valuing a company that is 100% right all of the time. To arrive at a reasonable price, you’ll most likely need a combination of tactics and procedures accordingly.
Author: Pooja S. – Jr. Analyst