Is Startup Valuation essential on Day 1? How & At What Valuation can Pre-Revenue Startup get fund?

Small beginnings lead to great achievements. Structuring & Valuing a startup on Day 1 correctly is a challenge. In the early days, startups don’t have enough money to hire excellent lawyers and tax advisors, experienced mentors or advisors. As a result, crucially important elements of the structure often get missed or are done the wrong way, and become a major reason for startup failure. But all these problems wither away with a magic wand and that is getting your startup valued on Day 1! Yes it’s Day ONE!! You read it correctly.

There is a famous saying: “Whenever there is a transaction, there is valuation”. It’s true. But the reverse is not true i.e. “Whenever there is valuation, there must have been a transaction”.

Why Valuation on Day 1?

Let me elaborate with an example, wherein two co-founders Peter and Jonathan initiate an idea of a health-tech startup, with an initial capital of $100K each. But the former is born with a silver spoon so can afford, later is blessed with intellect but can’t afford more than $25K. Without valuation and proper strategies on the basis of intuition both proceed, outcome is good, better and then WORST.

What if they would have done a proper valuation on Day 1? And would have also agreed on time and money invested. Many such mishappenings could be avoided. Lets see few important things to avoid such problems:

1. Agree on the capital structure at year three:

You should project how the capital structure and share register will look like after 3 years, maybe after 1 to 2 financing rounds. Both the co-founders above will need to do this rationally (not intuitively). The important thing is not to agree on the startup structure TODAY but what the structure will look like three to five years later. You should project how the capital structure and share register will look like after 3 to 4 financing rounds.

2. Start with the end goal:

You need to agree on exit strategy now. Both co-founders in the above example should decide how to exit viz., selling, acquisition, acquisition+hiring etc. Or even not to exit or continue milking the cow, and if exit then, When?

3. Agree on founder compensation and equity allocation:

Founder disagreements and disharmony are one of the most common causes of startup failure, and disharmony over an unfair equity distribution is one way to go down that path. In the above example, it’s essential to ascertain what weightage needs to be given to sweat vs cash?

4. Giving founders too much equity, and employees too little:

Unmotivated employees will not work and provide output as required for your startup. Employees must not only be passionate about their mission, but they should also have a nice payout to look forward to the same.

5. Agree on vesting, time based or milestone vesting:

Vesting is what prevents a co-founder from walking away after 6 months with a sizable chunk of a company’s shares, while time-based vesting is one in which stock rights ‘vest’ or are accrued with the passage of time, usually in annual/semi annual chunks. You can also opt for milestone vesting, in which shares vest following certain milestones.

6. Agree on Dilution Rate:

Dilution can dramatically impact the value of your portfolio. That’s the take home lesson from Binny Bansal’s abrupt exit from Flipkart. In his exclusive interview with Binny Bansal, the Flipkart unicorn startup founder shared one of his biggest mistakes he made was, diluting his business to a huge extent during early rounds of investment. Had he done the valuation correctly keeping in mind the value of business at the 9th year, he could’ve probably withheld much stake to himself.

To know more about various agreements and instruments, including founders agreement, which are essential & must on Day 1 of your startup and also anytime during the journey, irrespective of whether planning to raise funds, just go through our exclusive blog on Not just Statutory Compliance! Apply Internal Corporate Governance to Build Backbone of your StartUP!!

What are the chances of me successfully raising funds at the pre-revenue stage?

Now since you know why valuation on Day 1 is essential, let’s see & explore the probability of raising funds for your startup at the pre-revenue stage. See, the times have changed. Earlier the investors/fund houses were even funding at Ideation or Prototype Stages but due to increase in the number of startups in the last 5 years, the focus have been shifted to fund at post-revenue and scalability stages. Even today some startups get funded at the Ideation Stage also but they are rare.

Early stage valuations may also coincide with the startup being pre-revenue, meaning it is yet to generate any sales. This may be because it doesn’t have any product on the market yet. We can still determine the startup’s value, basing it on a variety of other factors. As a post-revenue startup, you have begun to generate sales and are now working through the stages of efficiency and scale. In the Efficiency stage, your sales and marketing processes are refined so you can generate consistent and growing revenues.

In the early stages, a startup’s true value is likely somewhere in the range of lower than what a founder hopes it to be, and higher than what an investor is hoping to pay for a portion of equity. When revenue is not in play, there are many other factors that become more important to calculating a fair startup valuation, and many of these factors can be quite subjective. There are many different elements that can be considered for a pre-revenue startup as a proof of potential, but really, which factors are most relevant and which are weighed most heavily is highly dependent upon the type of business itself.

Basis our extensive experience and research, below three factors contribute bigtime in obtaining a higher valuation for your startup at pre-revenue stage:

1. Founders – Who lays the foundation of edifice of your startup.

• Academic Skills Combination: A startup team should consist of several individuals, where everyone has a different but complementary skill set that can help in progress of the startup. Identify what skills are necessary to scale your startup and seek to fill in those gaps to increase your team’s overall value.
• Commitment & Dedication: Commitment is an act, not a word. Having a great founding team means very little if none of the team members are actually available to execute the required work. Build your team with highly-motivated individuals who are committed to bringing the startup to success.
• Advisory Board: Follow the advice you give to others. It’s not just your founding team that is important, but value can also be found in people who advise the board when making important decisions. Experienced advisors can help startups to avoid obstacles, make more informed decisions, and can even introduce them to potential investors or clients within their network.
• Proven Experience: Experience is the best teacher. Investors want to know whether the startup team has the skills to succeed or not. Startup founders that were previously involved in other successful startups are immediately valued higher than founders with no experience. A developer who had a significant position at a well-known software company may have an advantage when developing his own software. How, one’s experience can benefit a specific startup is subjective – but experience plays a major role in the way an investor perceives the associated risk of a startup.

2. Traction – Where are you going and How fast are you getting there?

These three concepts of traction are integral parts of each other and as a powerful marketing strategy will lead to impressive growth. When that happens, user numbers will surge.

Therefore, by providing proof that you have a viable, scalable business idea, you automatically add value to your startup. Investors start to look up to your startup as good mode to get more dollars.

• Customer Base: Proving you already have customers is essential. The more, the better.
• Effective Marketing Strategies: If you can show you can attract high-value customers for a relatively low acquisition cost, you will also attract the attention of investors.
• Growing Venture: Showing that your business has grown on a small budget is great, as many investors will see the potential for growth when you have some financial backing.

3. Future Financial Projections

Any time you are talking to an investor, whether in a pitch deck or during due diligence, they expect you to show financial projections. Many founders run into trouble with this when the company is mostly or entirely pre-revenue.

You might wonder what you can show with no track-record. Solid startup financial projections are the glue that keeps your business plan intact which is why they are such a fundamental ingredient of preparing a new company. Be clear about your business’s cash flow and make sure your balance sheet is consistent and shows that your startup is promising. If it’s transparent and realistic it will speak for itself. The below mentioned methods can help you in sales forecasting:

• Bottom-up sales forecasting for pre-revenue startups: A way of calculating the potential revenue for your company for a specific period by multiplying the number of likely sales for each product or product line, the average value of sales, and when they are likely to occur.
• Top-down sales forecasting for pre-revenue startups: A way of calculating your potential revenue by starting your assessment at a macro level to find market size and potential market growth, and then estimating your own revenue as a function of your assumed market.

The future is always uncertain, and no amount of projecting can ever completely eliminate that uncertainty. But, with diligence, you can be better-prepared in case the worst happens.

Methods of Startup Valuation:

The top two questions we hear for valuations are:

(1) How much should I be raising? So the thumb rule is to raise an amount that fuels you for 18–24 months.

(2) What valuation should I be raising at? See, valuing a pre-revenue startup can be confusing and challenging, indeed a tricky endeavor, because your startup has No Revenue and certainly No Profit. Many things need to be taken into consideration, few questions are to be asked right from: Trust, Idea, Execution, Enthusiasm, Exit etc. All factors to be emphasised right from the management team and market trends, to the demand for the product and the marketing risks involved.

One has to appreciate, startup valuations do not follow most valuation techniques used to value more established, later stage companies. Startup valuations are a lot more demand and supply driven, as opposed to numbers/metrics driven. Let’s explore the most popular methods with their applications:

1. Berkus Method:

“Pre-revenue, I do not trust projections, even discounted projections.” as rightly said by Dave Berkus. Typically for valuing pre-revenue start-ups that can be assumed to reach at least $20M in revenues in the first 5 years. Berkus method assigns “a number, a financial valuation, to each major element of risk faced by all startups, 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 valuation based on five elements:
1. Sound Idea (basic value)
2. Prototype (reduces technology risk).
3. Quality Management Team (reduces execution risk)
4. Strategic Relationships (reduces market risk)
5. Product Rollout or Sales (reduces production risk)

But the Berkus Method doesn’t stop with just qualitative drivers — you must assign a monetary value to each. In particular, up to $500K which is the maximum value that can be earned in each category, giving the opportunity for a pre-money valuation of up to $2-2.5M. Berkus sets the hurdle number at $20M (in the 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:

In the above spreadsheet, taking $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 easy, but the execution is everything). With so much risk undertaken by the investor, the startup’s management team must be fully capable of achieving long term success. The startup’s prototype ($300K) is sound, having minimal technology risk. Ultimately, I gave startup pre-money valuation of approximately $1.2M.

At a perfect score, a startup’s valuation tops out at $2.5M. The Berkus Method offers a highly simplified way to come up with a pre-revenue, pre-seed valuation estimation. While this method can be useful for applying a valuation to very early stage companies, it does have disadvantages, including the fact it is fairly limited in scope and that it doesn’t take the market or competitive advantage into account – both of which are very important in most cases.

2. Risk Factor Summation Method:

Also meant for pre-revenue start-ups, but slightly more evolved than the Berkus method. The idea here is to give a base value to a company and then adjust said value on the basis of 12 risk factors inherent to company building.

• Management
• Stage of the Business
• Legislation/Political Risk
• Manufacturing Risk
• Sales and Marketing Risk
• Funding/Capital Raising Risk
• Competition Risk
• Technology Risk
• Litigation Risk
• International Risk
• Reputation Risk
• Potential Lucrative Exit

The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250K for every -1 (-$500K for a -2).

3. Scorecard Valuation Method:

Valuation based on a weighted average value adjusted for a similar company. Mostly used by angels to value pre-revenue startups. Key to the Scorecard Method is a good understanding of the average (and range) of pre-money valuation of pre-revenue companies in a region. This method compares the target company to typical angel-funded startup ventures and adjusts the average valuation of recently funded companies in the region to establish a pre-money valuation of the target.

The next step in determining the pre-money valuation of pre-revenue companies using the Scorecard Method is to compare the target company to your perception of similar deals done in your region, considering the following factors:
. 0–30% Strength of the Management Team
. 0–25% Size of the Opportunity
· 0–15% Product/Technology
· 0–10% Competitive Environment
· 0–10% Marketing/Sales Channels/Partnerships
· 0–5% Need for Additional Investment
· 0–5% Other
The subjective ranking of factors (above) is typical for investor appraisal of start-up ventures.

4. Comparable Transaction Method:

Valuation based on comparing select metrics of your company with those of similar companies that have exited to determine a value.

5. Book Value Method:

Mostly irrelevant to startups as it works based on the tangible assets of a company, while startups typically tend to be valued on their intangible assets.

6. Liquidation Value Method:

Based on the scrap value of the tangible assets of a company and therefore, irrelevant to startups.

7. Discounted Cash Flow (DCF) Method:

Used for companies with revenue, but mostly irrelevant to post revenue startups due to the nature of startup/tech valuations. If you have sufficient base available, the discounted cash flows of revenues are available then in such cases we can apply this method also. As the name implies, this method involves projecting future cash flows of a business. Then, those cash flows are discounted to the present value, and the sum of all those cash flows is the present-day valuation. Thus, the DCF method attempts to estimate all these future cash flows and then calculate the present value of those cash flows.
Because the DCF method relies on accurately projecting future revenues, it is more suitable for mature companies with predictable growth rates and existing revenues. This is because if you try to predict what the future cash-flows of a pre-or early-revenue startup will look like, your best-guess is at best an approximation. The equation to calculate the net present value (NPV) of future cash flows is:

Pros and Cons of DCF Method

• Pros: can provide an intrinsic value of a business based on estimated future cash flows.
• Cons: “Garbage in, Garbage out”: it’s only as accurate as the cash flows that you predict. It’s highly speculative beyond a few years out, especially for startups where that is where the majority of startup value comes from (i.e. 5-15+ years out). Most appropriate for more mature businesses with predictable growth.

8. First Chicago Method:

The First Chicago Method allows you to take different scenarios into account. These scenarios are then combined into one weighted average valuation for your company. Takes the best, medium and worst case valuation scenarios for a company and provides a weighted average of those as the valuation. Startups have a very dynamic future. Thus, the valuation depends a lot on how your company will evolve. You and potential investors will have different opinions about the possible (and probable) future development of your business. Investors in early stage ventures with dynamic growth models often use this method because it gives them better results.

9. Venture Capital Method (VCM): VCM is a useful valuation method for establishing the pre money valuation of a pre-revenue startup. Calculating a valuation with VCM involves many assumptions.This is the reason why there is not one truth to the valuation. There are too many assumptions involved, which open a space for discussion. For you as a founder it is important to understand the basic mechanism. So you can discuss different scenarios and assumptions with your investors.This is the reverse math investors in tech startups run to reach a valuation number.

Let’s look at an example: We assume, our startup is in the clean-tech industry. Our investor will exit after 7 years (in 2027). He expects an internal rate of return of 30%. Our own estimated revenue in 7 years is around $6M. Using VCM, we get these results:

• Exit Value: $24.6M
• Post-Money Valuation of $3.9M
• Pre-Money Valuation of $3.2M
• Investor’s Share: 17.9%

So finally which Method of Startup Valuation to opt for?

Let’s have a bird’s eye view on all methods we have discussed so far:

The eligibility and probability of getting funded at the pre-revenue stage depends upon varied multi dimensional factors. Further the valuation method and approach differ between varied investors and funds. However an expert opinion can be established on these things by deep diving into all whereabouts of the startup. Which method shall I opt for my startup?

If sufficient data is available then we can go for the following methods in order : First is Balanced Scorecard Method, Second is Risk Summation Method, Third is Berkus Method, Fourth is Venture Capital Method, Next is First Chicago Method, then DCF Method and so on.

After evaluating everything and synthesizing, even with the most effective pre-money valuation formula, the best you can hope for the final estimate is still that – it’s an ESTIMATE. To ensure whether you are treading on the right path, it’s always recommended to get your startup checked as early as possible. Many founder have got their startups screened with Check My StartUP .

Check My StartUP is World’s #1 Unique StartUP Analysis Service for Fundraising & Internal Cash Flow Management comprising of:

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• Preparing or Revising Decks, Projections and Relevant Reports

Further, Fund My StartUP is World’s #1 Fundraising Syndication Service of its kind, from Angel Funds (AF), Venture Capitals (VC), Private Equities (PE) globally

• Service Delivery to initiate after “Check My StartUP”
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• Presenting your startup in Transparent’s wide Network of Investors

Transparent can guide you as to what method should be deployed for valuation of your startup and whether you have appropriately done the valuation or not. If you don’t feel so or need a second opinion, then Transparent can carry out the valuation of your startup with scientific proven techniques utilising the 200+ years of collective experience of our team.

At the current stage of your startup, are you confused about whether you should do valuation? If yes, then more confused on what method to be deployed along with assumptions and weights backing it? Then you can ask or suggest to others in the comments section below.