The critical period in which a startup’s founders are first getting their operations off the ground is known as the “pre-seed” stage. The most common pre-seed (also known as “early-stage”) funders are the founders themselves, friends & family, and angel groups. For example, one pre-seed startup that recently received funding from an angel group is Tumble. Tumble, a veteran-founded company, is bringing laundry day into the 21st century. Tumble machines leverage innovative technology like IoT, digital interfaces, machine learning, and other patent-pending solutions to provide customers with an unmatched user experience.
Tumble raised over $250K in funding from Hivers & Strivers; an angel investment group exclusively focused on pre-seed investments in startups founded and run by veterans. Hivers & Strivers has been quite impressed with Tumble’s founder, Scott Patterson’s. “As an Army guy, I am not surprised at all that it takes a mud Marine with combat experience to get the laundry done,” said General Partner of Hivers & Strivers Doug Doan. “This guy has what it takes to get this company up and spinning. We stand behind him and his vision for the future of the industry.”
Fundamentally, valuing a startup is very different than valuing an established company. Quantitative analysis and financial projections don’t always predict the pre-seed startup’s future success, which is why some angel investors put greater value in the entrepreneur and management team. Hivers & Strivers invested in Tumble, a pre-revenue startup, because of Patterson’s mental agility and integrity from serving in the Army combined with the huge market opportunity to disrupt an industry that hasn’t changed in over 70 years.
There is no one way to determine the pre-money valuation, the startup’s value before receiving outside investment. No matter the region, product, or industry, investors must reduce risk as much as possible, so it’s wise to gain insights on valuation methodologies from other entrepreneurs and angel investors. Being aware of every method could only help founders leverage and negotiate their valuation with investors. Below are three pre-money valuation methodologies that are often used by angel investors:
Scorecard Valuation Method
The Scorecard Valuation, also known as the Bill Payne valuation method, is one of the most preferred methodologies used by angels. This method compares the startup raising angel investment to other funded startups modifying the average valuation based on region, market, and stage.
The first step is to determine the average pre-money valuation for pre-revenue startups. Angel groups tend to examine pre-money valuations across regions as a good baseline. I recommend AngelList as a great resource to explore startup valuation data from thousands of startups.
The next step is to compare the startup to the perception of other startups within the same region using factors such as:
- Strength of the Management Team (0–30%)
- Size of the Opportunity (0–25%)
- Product/Technology (0–15%)
- Competitive Environment (0–10%)
- Marketing/Sales Channels/Partnerships (0–10%)
- Need for Additional Investment (0–5%)
- Other (0–5%)
The ranking of these factors is highly subjective, but the main emphasis besides scalability is on the team. Payne states, “In building a business, the quality of the team is paramount to success. A great team will fix early product flaws, but the reverse is not true.” Lastly, you calculate the percentage weights.
Venture Capital (VC) Method
The VC Method, first made famous by Harvard Business School Professor Bill Sahlman, works its way to pre-money valuation after first determining the post-money valuation using industry metrics. By applying the VC Method to solve for the pre-money valuation of a startup, it’s essential to know the following equations:
- Post-money valuation = Terminal value ÷ Expected Return on Investment (ROI)
- Pre-money valuation = Post-money valuation — Investment
The terminal value is the anticipated value of an asset on a specific date in the future. The typical projection period is between four to seven years. Due to the time value of money, the terminal value must be translated into present value to be meaningful.
By researching the average sales of established companies within the same industry (at the end of the projection period) and multiplying the figure by a multiple of two, we can calculate the terminal value. For example, let’s assume your startup is raising $500K and expecting to be generating $20M when you sell the company in five years.
- Terminal Value = $20M x 2 = $40M
The statistical fail rate for angel investments is over 50%, so investors typically target 10x-30x ROI on each investment. To be conventional, we’ll set the anticipated ROI at 20x for the pre-revenue startup. Knowing you’re raising $500K, we’ll then work the math backward to calculate the pre-money valuation.
- Post-money valuation = $40M ÷ 20x = $2M
- Pre-money valuation = $2M — $500K = $1.5M
According to a super angel investor, Dave Berkus himself, the Berkus Method “assigns a number, a financial valuation, to each major element of risk faced by all young companies — after crediting the entrepreneur some basic value for the quality and potential of the idea itself.” The Berkus Method uses both qualitative and quantitative factors to calculate valuation based on five elements:
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
But the Berkus Method doesn’t stop with just qualitative drivers — you must assign a monetary value to each. In particular, up to $500K. $500K is the maximum value earned in each category, allowing a pre-money valuation of up to $2M-$2.5M. Berkus sets the hurdle number at $20M (in the fifth year in business) to “provide some opportunity for the investment to achieve a ten-times increase in value over its life.”
It’s essential for you, the entrepreneur, to consider suggestions and methods to value your pre-seed or early-stage startup without existing revenue. How to estimate the value of your startup before raising investment from angel investors is paramount. It’s also important to understand your investors’ interests, such as the size of the exit they are striving for. However, there is no universal truth when it comes to valuations, so be prepared to be flexible.