Financial Modeling · Valuation

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

Shubham Shukla Engineer at KCG Holdings, Inc.

February 23rd, 2015

We are a pre-revenue start-up and are actively seeking investments to take our prototype to the next level.

From my research, I hear that VCs expect a start-up to make ~50 million in revenue by year 5 for it to be a viable investment opportunity for them. However, an average pre-revenue start-up is usually valued at around ~4-8 million.

With the first 5 year revenue of 50 million, how does one justify a valuation of just ~4-8 million? We plugged-in our numbers into a basic DCF analysis and even with the most conservative capex/opex estimates, our valuation came out quite high. What am I missing?

Is using DCF for pre-revenue start-ups a good idea? Are there any other methods that Angels/VCs usually use?

Also, what is a typical "Discount Rate" that is reasonable for a pre-revenue pre-money valuation for DCF analysis? We used 12 to 14% for our analysis.

Thanks!


Steven Vargas Product Manager at Hipmunk

February 23rd, 2015

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.

Instead, valuations are more like housing prices in SF. They keep going up because of the market more than anything. Now having said that, here's how investors (not all are the same obviously) think of valuation:

1) Ownership
   Most early stage VCs target a % of your company they want to own. That % will depend on a few things. For example, for industries that will require significant capital in the future, they may want to own more today. So they think of it as: How much money does the company need to get to the next stage? How much do I want to eventually own based on the potential of the company?
  The target ownership is determined mainly by looking at the amount they stand to make if your company is wildly successful vs the size of their fund. Most will like to have the chance to earn their entire fund back with one big winner. They may invest more to get to that ownership level (giving you a higher valuation) if they believe you can get to a big exit.


2) Market/signaling
    Most VCs look at the market rate for valuations, and make more of a binary yes/no decision. So, they ask "Do we like this company?", and then say "The market valuation for a company in this industry at this phase is $X." They know that if they don't adhere to the market, and instead only invest at lower pre-money valuations, then they will lose out on most big winners. VCs are under pressure to deploy capital, and would rather overpay for a company that could be a 10X winner than underpay for a company that they don't believe in.
   It also is a signal to the market if company A has a pre-money valuation that is below its peers. Some VCs will stay away. It's like if you tried to sell a car for well-below market value. It signals that something is wrong with the car.

3) Competition
          Really, this is the one factor that really affects valuation. You may think that having better traction, or an innovative business model will affect your valuation, but it doesn't. At least not directly. Not in some way that affects discount rate or anything. What those things will do is put your company in a position where more VCs will say yes to "Do we like this company?" and "Do we believe this company can get to a big exit?". This will bring you more offers, and that is the biggest factor in valuation.
     Here's a way to look at it: Most YC companies immediately have a 25%-50% higher valuation just because they graduated from YC. This is not because these companies have higher cash flow projections than non-YC companies. It's because VCs know that there will be competition to invest in these companies because many have a track record of future success.
      Now having said that, you can negotiate pre-money a little based on factors unique to your business that make an exit size bigger than industry norm. That will give you some bump in early stage valuation, but not as much as competition.

4) Future rounds / dilution
     The last point is that, as a founder, it's great to have a high valuation. But be careful of having a valuation that's too high or too low. If you're valuation is too high today, during the next round of financing, you put yourself in a position for a down round. This is a bad signal to investors and the market. Earlier investors will likely be diluted more than they'd like, and likely not participate in future rounds. 
     On the flip side, if you set the valuation too low, and you try to raise a large amount of capital, then you dilute yourself more than you'd like. VCs (and founders!) don't like the founding team to be diluted too much. It makes it tough to raise money later, as investors don't want to put money into a situation where the founders don't have much skin in the game.



So to summarize, valuation isn't set by looking at future cash flows or anything. It's set by what VCs expect to make if you are successful, which sets the market rate for your stage company in your industry. Deviations from that are based slightly on your specific metrics vs others, but mainly valuations change due to competition for investment in your business. If you try to negotiate valuation with a VC, they will likely pull other levers in the term sheet to give them advantages elsewhere.

Robert Clegg

February 23rd, 2015

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.

First, you say you've done your research - that's b.s. If you really had you'd know you aren't even close to the answer to this problem. In terms of meta-feedeback,  you have a huge blind spot. You've assumed your approach to this problem is the correct one and therefore only find answers you were looking for. The answers to this question is all over the internet. You just haven't looked or searched for it correctly. Go find it. This makes me suspect any other aspect of your business from competitive research, to any number of things.

Second, I can only assume you don't have the right advisors on board. This is a basic question that at a minimum experienced advisors should have been able to answer in 10 seconds. Go get real advisors.

Third, you aren't involved in a local startup community or startup program. This is super basic stuff for startups; presentations, meetups, and workshops abound. 

Fourth, your assumptions about what vc's are looking for is WAY off. And I don't mean numerically necessarily.

Fifth, doesn't sound like you have real legal representation with a track record of working with startups. If you did, ...

Sixth, I'm guessing you haven't raised friends and family. It's only a guess because if you have, I'm wondering how your legal time hasn't had discussions with you about how you bring in angels. And I'm wondering how you handled the valuation question there in the friends and family round. There are tons of legal firms that make presentations on this stuff.

Seventh, valuation is determined by competition and bidding. You think you are going to argue numbers with a vc? they only thing they respond to is competition for your company. a deal that's going to get way if they aren't on board. If no one else wants you it doesn't matter what your spreadsheet says. They just walk away. 


So - Get involved in your startup community, get a real legal team for startups, get real advisors, raise friends and family. This should save you 2-3 years of floundering around.

sorry if I assumed things you might already be doing. don't focus on that. I hope something here was helpful. Don't take it personal. Good luck.



Vincent Harris Entrepreneur, Filmmaker, CEO at Hoozip, Inc.

February 23rd, 2015

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.

Omar Hakim Technology Commercialization & Patent Monetization Professional | Expertise in Management Consulting & Startup Investing

February 24th, 2015

Shubham,

You're getting some great advice here - particularly from Robert C.

I've grappled with the question of determining pre-money valuations for pre-rev companies for some time now, both as an incubator manager and as an angel investor.

Briefly, here are some things to consider:
  • Bootstrapping and pre-sales need to be throughly explored (e.g. Kickstarter, etc.) before you look for outside cash.  
  • Nothing focuses the mind like scarcity - it will help you focus on getting the MVP into the hands of paying customers ASAP.
  • If you need outside cash, try to defer setting a valuation via convertible debt or maybe even establishing a "grunt fund" (http://slicingpie.com).
  • When it comes time to negotiate a pre-money valuation for a pre-rev company, starting by working backwards from a realistic exit valuation.  A startup will be far more likely to exit at $10 million than at $50 million.  Think of how many more potential acquiring entities there are who can afford to spend $10 million versus $50 million!  If you set too high a pre-money valuation at the beginning, then you may be closing the door to an early exit.  See Basil Peters' excellent book "Early Exits: Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists)"
  • If you have to raise outside money, try and structure your business model so that you can become cash flow positive (or at least get to break-even cash flow) using just the capital from the first round.  It makes your second round so much easier (and maybe even unnecessary).
Good luck!

Steven Vargas Product Manager at Hipmunk

February 23rd, 2015

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

First, the fact that you want to take your prototype to the next level and are looking for VCs is somewhat off-base. Typically, you'll want to raise some earlier money than VC money (F&F or Angel).

Second, I don't know where you heard that VCs expect a startup to make $50M in year 5 and calculate valuation accordingly. What pre-revenue investors want is that you are uniquely solving a problem in a big market, that the solution can scale, and that you have the team that can execute. What has driven the pre-money valuations so high are: huge exits by companies like Instagram and more invest money than ever.

Third, here's where the $50M annual revenue comes into play. VCs want to know that your company can be worth hundreds of millions some day in the life of their fund. If you show that in 5 years or 10 years, you will be at $2M/yr, then your company will not have an exit that will make them their fund back. For them, future revenue projections are a checkbox that you can potentially be big. Next question is whether they believe you will get there.

Fourth, the idea that you can plug projections into a spreadsheet to determine valuation is way off base. There are far too many factors and risks. It doesn't matter what discount rate you use. You don't have any revenue today. Every VC pitch has the same hockey stick graph, and yet 98% of startups go broke. There's no discount rate that can accurately project valuation.

Fifth and finally, valuations are subjective and non-linear. Your company is worth what the market will pay for it. But you also have to consider that you have to get over the "Yes" barrier to be worth anything. Think of it like salaries in sports. The best players in the NBA will have huge competition from teams and make a ton in free agency. If you're not quite good enough to play in the NBA, teams will pay you $0. Same for startups. If you're 1/2 as attractive to investors as a funded company, it doesn't mean you will have a pre-money valuation 1/2 of there's. Instead, your valuation will be $0. So focus on getting in the NBA. Your salary will be determined by how many teams want you.

Karl Laughton VP of Finance at Insightly

February 23rd, 2015

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

The most relevant method for you should be precedent financing comps... find a competitor and back-channel to understand what the pre-money valuation on their last round was. Then figure out how fast they're growing, what their operating metrics roughly look like, and how you compare to them. Apply a premium or discount to the pre $ based on that bench-marking and you'll have a defensible story to lean on.


Karl Schulmeisters CTO ClearRoadmap

February 25th, 2015

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. 

Rob G

February 23rd, 2015

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. 

Sanjeev Makker Assistant Vice President at Symphony Teleca

February 23rd, 2015

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

Karl Schulmeisters CTO ClearRoadmap

February 23rd, 2015

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