Valuation is fundamental to startup fundraising. Setting the tone when negotiating with your first investors is vital at the pre-seed stage. It determines equity dilution and signals the startup’s potential in the market.
Any well-informed founder must master early-stage startup valuation to show they understand a crucial part of their business and industry. Furthermore, correct valuation demonstrates an understanding of investors’ expectations, fostering confidence and trust in the early days.
Missteps in valuation can have serious consequences. Overvaluation usually deters angels or VCs from investing because it indicates naivety on the part of the founder. In other cases, it creates unrealistic expectations, putting pressure on the founding team. On the other hand, undervaluation could severely dilute founder equity. Dilution issues create challenges, affecting founders’ morale and possibly complicating future funding rounds.
For first-time founders, mastering valuation is critical to securing funding, strategic partnerships, and mentorship to help their businesses prosper.
Delving Into VC Business Valuation Methods
Before considering a raise, you need to think about how angels and VCs assess startup businesses. This will help you pitch effectively, hitting the key points by viewing your startup through their lens.
Venture capitalists evaluate startups using standard valuation methods tailored to the unique challenges of valuing pre-seed and early-stage companies. The following are the most commonly used approaches:
The Berkus Method
The Berkus Method is a well-known and widely used approach for pre-revenue startups. It assigns a monetary value to specific milestones in the business journey. These milestones reflect the business’s potential and how far it is toward becoming viable. This method is beneficial for founders who are building their startups at the earliest stages of development.
Five Components of the Berkus Method
The Berkus Method evaluates five components, each assigned a maximum value of $500,000. The components are:
- Does the startup have a clear, scalable idea addressing a real market need?
- State of prototype development: Has the team built a working prototype or MVP?
- Team quality: Do the founders and team members have the skills to execute their vision?
- Strategic relationships: Are there partnerships, advisors, or early customers validating the startup?
- Market opportunity: Is there a clear path to a large, addressable market?
To illustrate, a startup with a well-developed prototype, a strong founding team with sufficient skills and experience, and established industry partnerships might achieve a valuation of between $2 million and $2.5 million under the Berkus Method criteria.
The Risk Factor Summation Method
This method evaluates a startup by analyzing 12 risk factors that can influence its success. Each factor is scored as low, neutral, or high risk, with the base valuation adjusted accordingly.
The 12 risk factors under this method are:
- Management risk
- Stage of the business
- Legislation and political risk
- Manufacturing risk
- Sales and marketing risk
- Funding risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Exit risk
Computation under the risk factor method
The risk factor method evaluates a company based on its degree of risk. Low-risk startups receive an additional $250,000 and $500,000 on their base valuation. At neutral risk, no adjustments are made. VCs deduct $250,000 to $500,000 from the original valuation of high-risk startups.
The model is straightforward. A biotech startup with low technology and market risks but with considerable competition and funding risks will likely have deductions from its base valuation. If initially valued at $2 million, the startup could undergo adjustments and yield a final valuation of $1.75 million.
The Venture Capital Method
The Venture Capital Method (VCM) is a preferred valuation method among VCs. It was developed in 1987 by Bill Sahlman and focuses on predicting a startup’s future returns. The VCM calculates the company’s valuation based on its potential or expected future value and also considers the investor’s desired return on investment (ROI).
The Venture Capital Valuation Method, or VCM, involves a multi-step process. First, VCs estimate the required investment. Next, they forecast the startup financials and determine the exit timing via M&A or IPO. Afterward, they calculate the multiple at exit and then discount to PV or post-money value at the desired rate of return. Lastly, they determine the pre-money valuation and desired ownership stake. VCs usually aim for 10x to 30x returns at the pre-seed stage.
After the initial steps, they work backward and use the standard formula for this model to calculate the final pre-money valuation.
The Market Multiples Approach
The Market Multiples Approach is based on the valuation theory of similar assets selling at comparable prices. Thus, it uses industry-specific benchmarks to value startups based on critical metrics such as revenue, users, or subscriptions. While typically applied to later-stage companies, it can provide valuable insights at the pre-seed stage when revenue forecasts are available.
Common ratios used in this method include enterprise value multiples and equity multiples. Examples of enterprise value multiples include enterprise-to-value sales ratio or EV/sales, EV/EBITDA, and EV/EBIT.
Investors often apply discounts to startups at the pre-revenue stage, making the market multiples method less precise for early-stage ventures.
Discounted Cash Flow or DCF Method
Though less commonly applied to pre-seed startups, the DCF method is still worth knowing. It bases investment value on future cash flows and discounts them to their present value using a discount rate. This method is ideal for startups with reliable financial forecasts.
It has limitations, however, including:
- The assumption of consistent revenue, which is rare at the pre-seed stage.
- The sensitivity to assumptions about growth and discount rates.
The Startups That Got it Right: Successful Early-Stage Raises
While early raises are tricky, founders can learn from the companies that navigated pre-seed valuation successfully. The following companies secured substantial early funding, setting them up for eventual success:
- Robinhood: Robinhood’s founders raised $3 million in seed funding. Focusing on a disruptive business model, they attracted early investor interest despite having no working product.
- DoorDash: In 2013, Y-Combinator grad DoorDash raised $2.4 million at a pre-seed valuation of $15 million. The founders emphasized the untapped potential of last-mile delivery. They used the money to expand engineering and operations.
- Figma: The remarkable startup raised $3.8 million at the pre-seed stage. The founder is a Thiel Fellow. He built a platform that offered cloud-based design tools, which resonated with VCs. The funding head start eventually led to Adobe’s $20 billion acquisition.
Ensure Eventual Success by Mastering Startup Valuation
For VCs, business valuation is the most crucial element to be negotiated on a term sheet. Thus, to pitch and effectively connect with VCs, pre-seed founders must cultivate valuation as a skill.
By deep-diving into the criteria, methods, and formulas that make up valuation models, founders can confidently navigate the complexities of early-stage funding. Mastery translates into turning early-stage hurdles into strengths.
In an increasingly competitive startup landscape, you can stand out by mastering valuation strategies that help you pitch effectively and secure funding. Remember that a solid pre-seed valuation sets the foundation for growth, positioning your startup for long-term success.
Image Credit: Photo by Austin Distel on Unsplash
