How Much Is Your Pre-Revenue Startup Worth?
What is the value of your pre-revenue startup? How much does your innovative new business affect your personal net-worth? Is there some sort of specific method you should be using to determine company valuation? The answer in finance is always “it depends.”
I have encountered a lot of entrepreneurs recently who have been trying to answer all of the above questions. The simplest answer is probably the most annoying - the valuation of your business is what someone is willing to pay for (a part of) it. At the end of the day, there are millions of ways that financiers through the years have used to try and determine value, but the only one that really carries weight is what price clears a market transaction.
Unfortunately, that is not very good advice and the whole reason I am writing this blog is to try and give some good advice. So what should an entrepreneur do when negotiating the value of his/her company? There are a handful of things to keep in mind.
When you crack open any finance textbook, it will tell you that the value of a company is based on future cash flows. But, if you are a pre-seed company without any revenue, and you are trying to value your company based on projections, you are probably going to have a hard time. Now there are certainly exceptions to this rule (more than I would like to admit), but most venture capitalists don’t pay much attention to projections for valuation purposes pre-revenue. Projections are super important in order to better understand a business model and a management team’s strategy, but without any prior history of product/market fit, they can’t tell you much about worth from a technical perspective. That isn’t to say that an entrepreneur should avoid projections altogether, however. Make sure they are professional and well thought out - VC’s are making a “bet” on the management team and if they can’t put together a decent set of projections, that’s not a good sign.
So instead, the best method for valuing a company is basing it on the rest of the market. This puts some entrepreneurs in a precarious position because they are likely not up-to-date on recent market trends, whereas whoever they are negotiating with probably is involved in the market daily. So this requires an entrepreneur to do some homework. That homework might include in-depth research, talking to other founders, talking to friendly VC’s, and pursuing multiple term sheets. The point is, a founder needs to understand what other, comparable companies to theirs are worth. From there, they can have a touchpoint to value the company.
But even once a founder determines valuation, is that all that matters? Definitely not. Getting the actual number right probably isn’t as important as all of the terms that surround it. Instead, founders need to think of valuation as a tool in their strategic toolkit. First, an entrepreneur has to consider how much of their own personal stake they are selling to an investor. Are they maintaining enough equity to stay motivated long-term? If a Company is truly high-growth and able to achieve massive scale, a small piece of that pie will still generate an impressive capital return. But the definition of impressive capital return is different for everybody, and every founder needs to define for themselves what they consider a success.
A founder should also consider if their capitalization table has a big enough option pool. Building a company relies so heavily on building a great team. And since a startup needs to focus on having a responsible burn rate, one of the best ways to recruit good talent is to get them to own a piece of the company through stock options. If an investor takes a big chunk of a business and leaves nothing for future employees, that’s not a good position to be in down the road. So when determining valuation, a founder needs to really appreciate how big of a team they are going to need to succeed.
With that in mind, it is important to note that most investors have a target of how much of a company they want to own. Pre-seed VC’s typically land somewhere between 5% to 25% when they purchase a piece of a business. These figures are typically based on the return profile they are trying to achieve for their investment. A lot of times, this figure will help them determine what value to place on a startup they are investing in. This is important to note because when a founder is raising money, they need to keep in mind that if they are only raising $300,000 and they value their company at $10 million, that probably is not enough for a VC to be interested. And if you are trying to attract capital, you need your VC’s to stay interested.
Another, more underrated aspect of valuing a startup is understanding what the next valuation could/should be. That is where market research can be more thorough - take advantage of various databases, blogs, and finance professionals. Because the last thing a founder wants is to overvalue their first round of financing and then have a down-round for their next financing (a lower valuation). This can be poison for a startup because it drastically reduces the demand for a startup’s fundraising round. It also can affect how much of the company each shareholder owns due to various anti-dilution provisions that exist in the original deal documents. So what seems like a great deal at the pre-seed stage for common shareholders can end up causing disaster at the seed stage if a company doesn’t perform up to expectations. Being an entrepreneur frequently means being an incredible optimist, but sometimes it pays to think rationally.
At the end of the day, however, great founders don’t focus on something that is out of their control (market terms for a valuation - these always change). They focus on what they can control. If they do good work, their early valuation won’t matter all that much. Their job isn’t to be a market maker or to nail valuation for something so opaque - their job is to build a great business.