What pre-money valuation method to use for pre-revenue start-up?

VCs absolutely do not use DCF for early stage valuations. Projected cash flows have no meaning when you have no revenue today. You would not be taken seriously by even mentioning DCF as a valuation method.

Hi Shubham - this is going to be very blunt, some may consider it rude, some may see it as painfully helpful. If this is not the kind of input you are looking for, just skip this reply.

I don't claim to have the answer to your question as valuation of pre-rev co's is more art than science. I can tell you that DCF is an inappropriate method for a business at such an early stage. DCF assumes consistency of cash flows. Ramping up the discount rate, no matter how high, cannot offset a complete lack of real cash flows to plug into your model. At this early stage of your business, may be better to use some sort of intrinsic value approach, i.e., value of the founders investment of time/money times some multiple. If you have real IP, i.e., patents there's a way to value that too. But I think you will lose credibility with a sophisticated investor if you whip out a DCF on a company that $0 earnings.

Venture rates of return to reflect execution risk of a pre-revenue start up are 40-50%, adjust your discount rate accordingly.

Robert, you are blunt! But also very right. Shubham, a few things to consider:

Listen to Robert.  Stop worrying about your pre-revenue valuation and build a PoC.   I'm guessing from your CV that you are looking to do some sort of Robotics or Machine Learning based solution.  The latter of course is preferable to the former as the latter is more a matter of writing some code and then acquiring the data whereas the former is capital intensive for the Minimum Viable Product development, then more capital for the regulatory side  (most of which I suspect you have not really sorted out yet) and then even more capital for the production tooling.

So if you are going Robotics, you are 3 years minimum before you have a launch.     Now consider that from an angel investor perspective (I'll pretend to be the Angel):

You are asking me to give you $1 million.  on the promise that your company will be worth $10,000,000 in three years when we exit by getting a VC to do a Series A investment.   That means that you will have to be able to convince someone that in 6 years fro today you are a $100,000,000 company.

IE that in 6 years you will have between $10 million and $20 million in sales.  Is this realistic? No?  Then I'm investing in something that is less risky but which gives me the same payout.

OR alternatively I give you $100k and expect $1 million in three years from a VC that expects $10 million valuation 6 years from today.  IE that you have a company generating $3mill - $5 million in revenue.

now maybe you have that.  I don't know what your idea is.   But if you haven't gone for Friends and Family money - I seriously doubt that.

and if you have not been able to pull together $100k in Friends and Family money and by taking out loans against your Microsoft 401k  -  enough money to put together a pretty decent robotics prototype after all if the Carl Hayden kids could do it for $800 you guys should be able to do something decent for $100k.     And if 2 or three guys from Microsoft earning $100k+ each can't put up $100k of their own money for something this risky, I the Angel Investor sure won't. 

Your valuation calculations won't give you this answer.    because what it comes down to is that I'm looking for thought out roadmap to 10x my money in 3 years.  And the VC I plan to sell to is also looking at the same thing. 

and the reason is simple.   Odds are you will fail.   

70% you will fail completely - total writeoff with nothing to salvage

if you are not in that 70% group where I write off my $100k,  then you are 2/3 likely in the group that does not break even.   So I lose part of my $100k

If you are not in that 90% that loses money,    50/50 you underperform the S&P 500.   ie 95% of the time I would have been better off putting my money into the stock market

of the remaining 5% , 3% roughly will make the 10x.  so if I have  $10million to invest and I give 100 companies $100k each... 98% of my investment will earn me a reward of $8 million.   I'm counting on that top 2% to make up the balance of the $14 million in profits that a VC or angel would expect to make

So not only do you have to show me that you have a realistic roadmap to 100x ROI in 6 years - but you have to show me that there is a chance that your upside potential is closer to 1000x ROI in 6 years.

No amount of jiggering of discount rates will show that.  You have to show value, you have to show price points and you have to show that its reasonable for me to believe you can do that. 

http://fundersandfounders.com/how-startup-valuation-works/ See this infographic which will give you an idea on how valuation works in a start up world.. Thanks Sanjeev Regards, Sanjeev

What Steven and Robert have said. It sounds like you aren't even "pre-revenue" but really you are "pre-prototype". Build the prototype. Show that you can attract demand to it (one person in these forums shows that she had a pre-order base of over 150 customers signing up per week).

Work out specifically what you will use the money for

Cut that in half without cutting the features/workload

Now show how your revenue model shows 10x year on year growth with realistic numbers.  Remember this is 10x from the moment you get the money, not from the moment you enter the market.

Your Angels will typically want a realistic 10X exit in 2-3 years

your Round A seed will want the same.

Lastly remember that how other people's money works is that THEY GET PAID FIRST. so if you bring in an Angel say for $100,0000 - with a three year $1 million exit - and in three years your company is worth $1.1 million - they will force you to sell, they will get their $1 million, and you will have $100k for 3 years of work REGARDLESS of what percentage of the company they own.

percentages of companies only matter when you actually succeed. So avoid Angels and VCs as much as possible. Go the Friends and Family route. If you aren't comfortable taking money from your family for this idea - you probably don't believe enough in it to have a chance at success

Shubham, you haven't mentioned what your startup does (or will do).  The only way a DCF has any bearing on startup valuation is if you are starting a consulting company or non-tech company, neither of which will attract VC money (with few exceptions).  So, if you intend to raise VC then forget discounted cash flow - save that for the group of dentists who want to invest in a 'traditional' widget company or restaurant chain.  To add to what Robert C and Steven V have said (listen to them), valuation also depends on location which is in tern tied to competition (between VCs).  In the Bay area there is lots of VC competition which drives up valuations.  There is no other startup market in the world like the bay area - same goes for valuations of bay area companies.  If you are in another top tier (2nd tier behind the bay area) market like NY or Seattle, or Austin you will see pretty consistent valuations for 'comparable' companies.  So if you are in Seattle, look for comps in Seattle.  If you are in Kansas city... move to San Francisco.  You also did not mention if your company is focused on consumers or businesses. B2C valuations are much more affected by user growth and revenue at your stage has little to do with it. not the case for B2B where revenue or the prospects of revenue (i.e. signed contracts) actually mean something. As Robert and Steven have said, its really about competition - investors need to invest their funds.  They have models for how amy investments they can effectively manage and based on the size of their funds they have practical limits on how LITTLE they can invest and the % they typically want to own at each round.  They want to strike a balance between owning too little of your company (and putting too little of their capital to work for the effort) and owning too much which can cause problems ranging from incentives for founders to discouraging follow-on investors.   So that's a long way of saying, in Seattle if you have a VC sized addressable market, a functioning product, a solid team and some traction (rapidly growing user adoption for B2C or revenue or contracts for B2B) then you are looking at $4-6M pre money. That's about as sophisticated as the calculus gets.  If you have more than that then you can get a higher valuation.  If you have less than that then your valuation is closer to $0. Exceptions are if you have a super talented team, even just a couple of very talented developers can get you a decent 'valuation' - effectively an acquihire (not VC investment).  Contrary to a couple of other posts herein, don't put much stock in patents as even when you have issued patents in hand they are exceedingly difficult to value.   They are one more data point in your favor if you are already attracting VC interest, but don't try to put a $$ value on them at this point.  They are worth what someone is willing to pay for them. Good luck. 

Shubham,