After months of bootstrapping their start-up, most entrepreneurs get to a stage where they need outside capital to fully develop their product and to start generating some revenue or profit. At this stage, the founders open their company to investors and offer them a deal:
You give me Y amount of Swiss Franc and you get X percent of our start-up. But how much is X?
In practice, X depends on the pre-money valuation of the company, i.e. the value of the start-up before the investment. But how do you get to the pre-money valuation?
Traditional Valuation Methods
The valuation of mature companies is – at least in theory – a straight forward process. It involves some subjectiveness, but applicable valuation methods have been around for quite some time. The valuation can be based on the current assets of the company, on market multiples or on the current or future (expected) cash flows of the company. All these methods however require many years of financial data or a company that has substantial (tangible) assets on its balance sheet. All of which, new ventures usually do not have.
Ways to Determine the Value of Your Start-Up
Start-Up valuation requires a different approach than the valuation of a mature company, particularly in seed financing rounds. At that stage, the value of a start-up is driven by its traction, its reputation (or founders' reputation), the (potential) revenues and the "hotness" of the industry the start-up is in. Whereas transaction multiples might be available, tangible assets are often not in the picture.
Despite having no historical data, start-ups sometimes have detailed business plans with cash flow estimations which (in theory) allow the application of the Discounted Cash Flow Method. But honestly, how accurate can estimations of future cash flows be without any historical data or data from similar business models? Not very, in my opinion.
As such, one often says that valuing early-stage start-ups is often more art than science. However, the industry has come up with different valuation methods that consider the special nature of early stage start-ups:
- The Berkus Method: The Berkus Method was devised by Dave Berkus, a business angel and is generally used for pre-revenue start-ups. It is based on the assumption that the company to be invested in has the potential to reach USD 20 million of revenue by the fifth year of the business and assesses the company against five criteria (Sound Idea, Prototype, Quality of the Management Team, Strategic Relationships and Product Rollout or Sales). Each criterion "earns" the start-up a higher valuation or leads to a lower valuation. With the Berkus Method, the maximum pre-money valuation to be achieved is USD 2 Mio. For more on the Berkus Method, see here.
- Scorecard Valuation Method (or Bill Payne Method): Using this method, you establish a certain base valuation for the company (e.g. by using the Discounted Cash Flow Method) and adjust it against a set of criteria which have an impact on overall success of the venture. The criteria themselves are weighted against their impact on the company and its future. Bill Payne, an angel investor uses the factors Management (30% weight), Size of Opportunity (25% weight), Product/Service (10% weight), Sales Channels (10% weight), Stage of Business (10% weight) and other factors (15% weight). More information on this can be found here.
- Risk Factor Summation Method: This valuation method adjusts a determined pre-money valuation (e.g. based on the Berkus Method or the Scorecard method) against certain risk factors (such as Management, Stage of Business, Legislation, Sales and Marketing, Technology, Reputation, Competition). If a certain factor positively impacts the future of the company, the valuation is increased. If a risk factor may negatively impact the company, the valuation is decreased. For more on the Risk Factor Summation Method, see here.
- Chicago Method: The Chicago Method addresses the problem and risk of estimating future cash flows by generating three scenarios: Success (Best Case), Survival (Base Case) and Failure (Worst Case) and estimating their probability. By addressing all three scenarios, you have more balanced view on the valuation by looking at the probabilities of the different outcomes and by taking a weighted average. For more information on the Chicago Method, see here.
- Venture Capital Method: The Venture Capital Method is a valuation method that takes the view of the investor and bases the valuation on a certain expected return on investment. As such, the valuation starts with the exit or terminal value, i.e. the expected value of the firm at the time of the IPO or the sale. This value is then discounted to the present at the target rate of return which describes the required return given the risk that is associated with the investment. The target rate of return of Venture Capitalists in seed rounds is around 30% (Target Net IRR) and thus substantially higher than the traditional cost of capital. To read more on the Venture Capital Method, look here.
So, how should you go about valuing your company? This really depends. You certainly should look at the valuation methods described above in more detail and think about the main factors that drive valuation, such as management, comparable transactions, risk and potential return for the investor. However, based on my experience, the best way to go about valuing your early-stage start-up is somewhat different.
What I think is the best way of valuing your company
After bootstrapping for a certain amount of time, the goal of your first seed round is generally to cover the cash burn until the next (planned) financing round. As such, your thoughts when valuing your company should be as follows:
- First, you need to think about how long you want to wait until the next financing round. The longer the duration until the next round, the more money you need. However, bear in mind, the more money you ask for, the more risk is associated with the investment (from an investor's point of view) and the lower the valuation. On the other hand, if only raise a small amount, the valuation might be higher but quickly after the first round, you already need to think about the next round. Short durations between financing rounds are therefore only recommended if you think that an event in the near future will have a significant impact on your valuation. Otherwise, opt for a larger round and a longer duration until the next financing round.
- Second, you need to think about how much money the company needs and how the money is going to be deployed. What are you going to do with the investment? What do you want to have achieved by the next round? This is where your management skills come into play. You need to have a clear vision of what you want to do with the money and present it accordingly.
- Third, you need to think about how much you are willing to be diluted in the first round, i.e. how much of the company are you willing to give away. The answer depends on many different factors and should be considered very carefully, taking into account the number of required (future) financing rounds, the expectations of the investor and the kind of control you want to have in the long term. In practice, seed rounds dilute founders' equity by around 15%.
Overall, the economics (i.e. company valuation) of the financing round is just one aspect. Another important aspect are the deal terms and particularly the control rights and the impact an investor can have on the company. Smart money always qualifies for a higher ownership than a pure financial investment. As such, every founder team needs to have a clear and honest dialogue with investors about heir intentions and need for control.