Early-stage startup valuation is an important topic for both founders and venture capitalists. On one side entrepreneurs want to receive recognition for their achievements so far, while on the other investors require comprehensive and adequate pricing methodology for pursuing an investment in a particular startup. However, because of the nature of the startup business and the development stage it is at, most founders seeking seed funding from angel investors, venture capitalists, or corporate accelerators struggle determining the right value of their technology venture. In most cases attracting seed funding means that a startup has negative cash flows, does not have revenues (not to mention profits), maybe but rarely possesses intangible assets in the form of an established brand or a patent deterring competition from entering their niche. Thus, using traditional valuation methods (usually in the case of public companies with millions worth of revenues) is especially arduous. As a result, you should use a set of methodologies that are typical for the specific purpose of valuing a deal at the seed stage.
Still, just like for any other market, a good starting point for drafting an initial range for an early-stage startup valuation is comparable deals. For instance, if you are in the B2B SaaS business, what valuations did similar startups in your region score when fundraising? As implied, this method should not be used exclusively, but rather as a reference when using other methods.
Venture Capital Method
Without a doubt, one of the most cited and used ways to calculate the value of an early-stage startup is the Venture Capital Method first mentioned by Prof. William A. Sahlman at Harvard Business School in 1987. There is also a revised paper on the topic available online by the Harvard Business Review here.
The VC method is an intrinsic approach of valuing a startup. It essentially is a mix between multiples and DCF valuation. First, a startup’s net income is projected for a terminal year, usually between 4 and 7 years from present. Then, a Price-to-Earning ratio, based on industry multiples for companies with similar characteristics, is used to estimate a venture’s terminal value. This projected value is then discounted by a relatively high discount rate, usually between 30% and 80%. This is due to the fact that VCs take extremely high risks by investing in startups and thus demand high returns in exchange. The end result is the post-money valuation of an early-stage startup. So, if a startup is seeking $500K with post-money valuation of $2M, then an investor will require 25% share of the company. This also means that the value of the company before securing any form of financing is $1.5M.
The VC method is particularly useful when accounting for dilution in subsequent financing rounds. However, obvious flaw of this method is inherited in the questionable ability of the entrepreneur to accurately forecast the revenues and costs of her venture for the subsequent 4 to 7 years.
Another method for valuing your startup is the Scorecard Method. This method compares, for example, a seed-stage startup to typical seed financing seeking ventures while adjusting the median pre-money valuation for seed deals in a given region and vertical based on 7 characteristics of the company. First, a median is obtained for the average pre-money valuation of a seed-stage startup in the region and the business vertical. Let that be $2M. Second, using 7 specific factors with different weight contributions, a target startup is compared to an average startup case. Consequently, valuation of the target startup might be valued at a lower or higher price compared to the market average.
I particularly like the Scorecard valuation method as it accounts for local characteristics of the startup ecosystem, hence being able to value differently startups at the same product development stage, but located in different regions. Obvious flaw of this method is that it implies that there is available data for the local ecosystem and for the particular vertical, which is not always the case.
At the end it is important to note that startup valuation can significantly differ depending on the level of competition and on the business cycle. It is particularly difficult to raise money for your venture during times when money is an extremely scarce resource. If you want to explore more about this topic, you can read about Ben Horovitz and his experience of raising money during the 2000 dot com bubble burst in his book “The Hard Thing of Hard Things”. Actually, just read the book for whatever purpose. It’s a great read!
Purpose of this post is to inform the wider public on the various methodologies needed and available for an adequate seed-stage startup valuation. In the coming weeks, I will cover the VC and the Scorecard methods in more details.