The question of how to value a business never has an easy answer, but it is a particularly complicated question for startups.
Business valuation is “a general process of determining the economic value of a whole business or company unit.”
So, when we do a pre-money valuation we want to determine the monetary value of the business so that we can decide on the value of each share within the company.
This is because typically you need a valuation when a business needs to secure funding, either in the form of cash investment or sweat equity, in exchange for shares.
Valuing mature businesses is simpler than valuing a startup, as we have a lot of data available to help us determine the monetary value of the company.
But with a startup, especially one that does not yet show revenue growth, it is more complex as we don’t have concrete data and there are additional management risk factors that need to be taken into account when performing the valuation.
We are forced to value the startup based on estimates, rules of thumb, founders’ previous success, and educated guesses. This is why it is often said that valuing startups is more art than science.
Ultimately though, the valuation of a startup is determined by what the founders and investors agree upon during negotiations.
But to ensure that the valuation settled on during negotiations is as accurate as possible, it is crucial to understand the factors that go into a startup valuation both from the founder’s side and the investor’s.
If you are a founder planning on raising funds, you are in the right place. In this article, we will look at the following:
💵 How to value a startup that is generating revenue.
💵 How to value a startup with no revenue.
💵 Important factors to consider for pre-revenue startup valuations.
💵 What to consider as a founder when valuing a startup.
💵 Valuing a startup from an investment perspective.
There are several ways of valuing a revenue-generating business, including:
Times revenue method
An earnings multiplier
Discounted cash flow method
Book value, liquidation, or exit value
However, for businesses that generate steady earnings and revenues, the most common valuation measure used is EBITDA combined with a market multiplier.
EBITDA stands for "earnings before interest, taxes, depreciation, and amortisation". The idea behind EBITDA is to calculate the cash profit generated from the products or services your business delivers.
All of the information necessary to calculate EBITDA can be found in a company's financial statements, and the formula typically used to do the calculations is:
Depreciation is an accounting method that is used to spread the cost of a physical asset throughout its useful life. So instead of a company booking the total cost of an asset it purchased in year one, it can spread it out over a period of time using depreciation.
Amortisation is essentially the same thing but used to spread the cost of intangible assets, e.g. patents, trademarks, and copyrights, over a specific time, typically over their useful life.
To get to the startup’s valuation you would first calculate this figure for a business and then multiply it by an industry-specific multiple.
For example, SaaS businesses with recurring revenue are typically valued as being worth between 10x and 14x EBITDA, so a SaaS business with an EBITDA of £1,000,000 should be worth between £10,000,000 and £14,000,000.
If your startup is generating earnings and you can calculate your EBITDA, then applying the average multiple for your industry should give you a good indication of the value of your business.
However, as a pre-revenue or early-stage startup with no earnings, your EBITDA isn’t a useful tool for valuation.
It might be more art than science, but there are still several startup valuation methods for a startup company with no revenue.
We will explore a few of the most popular startup valuation methods here.
However, first, we will look at some of the factors which venture capital firms consider when investing in pre-revenue startups.
Important Factors for Pre-Revenue Startup Valuation
Several factors will influence the valuation that investors are willing to accept. Here are the ones which we think are the most important, and which you can work on to increase your valuation.
💡 Founders/Management Team
The value that investors place on the founding team shouldn’t be underestimated.
Since investors don’t have a lot of data to go on, they want to be sure that they are backing a team they think will be successful.
Having a founding team with a proven track record is a good indicator of success, but investors also look for a team with the appropriate mix of skills for the business and a strong commitment to the business’s success.
💡 Minimum Viable Product
Showing investors that you already have a Minimum Viable Product tells them that you can execute your ideas and immediately increases their confidence in the business's chance of success.
Even if you are not yet generating revenue from your user base, showing that you already have some traction in the market gives you a strong proof of concept for your product or service.
Having a user base with a positive growth rate proves to investors that you have a viable scalable business.
Or, if you have not yet launched your product or service, a great way of showing traction is to build a pre-launch waitlist. This proves there is interest in your product and creates customers who are ready to purchase once you launch.
Now that you have an idea of the factors you can tweak to increase your valuation, let's look at how to approach valuing your business when pitching for investment.
How to Value a Startup: Founder’s Perspective
When pitching investors for funding, you will need to provide a valuation of what you think your business is worth, as you will need to be able to put a monetary value on the amount of equity that you are willing to give away.
This means that when creating your pitch deck, there are three things that you as the founder will need to consider when providing your valuation:
🔸 How much money do you need to raise?
🔸 What is the percentage of equity that you should sell?
🔸 How do I justify my valuation to investors?
Answering the first two questions will get you to a valuation number, so let’s look at how to answer them.
How Much Do You Need to Raise?
The answer to this question depends on the stage that your company is in. However, for a pre-revenue company looking for seed funding, you’ll want to raise enough money to get to profitability.
However, most startup companies won’t be able to convince investors to give them that much money during the first round of funding, as the risk factors are simply too high.
So, a good rule of thumb is that you want to raise enough money to last you 12-18 months before you will need to raise it again.
This is because fundraising takes time, so you want to give yourself sufficient time before having to go through the process of pitching investors again during a subsequent round.
So how do you know how much money you need for 12-18 months? To do this calculation you need to look at your current monthly burn rate and then factor in any additional expected costs, e.g. new hires, marketing costs, overheads, etc.
One thing to keep in mind is that you should also think about your burn rate in terms of the milestones that you want to achieve with the money that you are going to spend.
Once you have this number, multiply it by the number of months you need to get to the amount you need to raise. This amount together with the percentage of equity you are willing to exchange for it will get you to your valuation number.
An important thing to remember is that when pitching to investors you will want to frame this as the amount that you require to get to the milestones needed for success, and not as your burn rate.
How Much Equity Should You Sell?
There isn’t a definitive answer to this question, but a good rule of thumb is that during the seed round you should expect to sell between 10% and 20% of your total equity to investors.
Investors in early-stage startups are in a high-risk/high-reward investment scenario, and thus need to own a significant percentage of the businesses they invest in to make a decent return on those that end up being successful.
Some investors also want to reduce risk by having a significant level of control over key company decisions. For this to be possible, they need to have a meaningful ownership stake in the business.
What Is Your Valuation?
Now that we know how to determine what you will need to raise and what percentage of equity you should expect to sell, we can calculate your valuation.
For example, let’s say that you have a burn rate (including expected expenses) of £5,000 per month, and you want to raise enough funds for the next 18 months.
To do so, you will need to raise a total of £90,000.
If you can sell 10% equity for £90,000 during your seed funding round, this will give your startup a valuation of £900,000.
However, investors will not necessarily agree that your business is worth that much, so before pitching to them it is useful to know whether you are getting to a reasonable valuation.
A good way of doing this is to use available industry data to see what the valuation of other similar startups is.
To do this we can look at available data for valuations by stage.
Valuations by Stage
SeedLegals is a UK company that provides startups with the legal documentation and support they need for funding.
They are the number one provider for funding rounds in the UK and have drawn on their database of early-stage funding rounds to put together a handy guide of ballpark valuations for UK startups by stage.
According to their data, the ballpark valuations by stage for pre-revenue startups in the UK are as follows:
🔹 Idea Stage: £1,000,000
🔹 Product Build Stage: £1,300,000 - £1,500,000
🔹 Product Launch Stage: £1,500,000
🔹 Traction Stage (You have some traction but no revenue yet): £2,000,000 - £3,000,000
This gives you an idea of what a reasonable valuation for your business is, and the business from our example above falls within the reasonable range for a UK startup in the idea or seed stage.
These numbers are of course only an indication, and your valuation could be much higher or lower depending on several factors. Also, these numbers are specifically for the UK, and valuation numbers in the USA are much higher, with seed-stage valuations averaging around $12,000,000 (about £10,600,000).
However, sophisticated early-stage investors like venture capital firms and angel investors will typically have their own models that they apply to determine what they think a pre-revenue startup is worth.
This then helps angel investors and other interested parties to decide how much they are willing to invest and what percentage of equity they want in exchange.
It is useful to have some understanding of these models when entering into negotiations with them.
How to Value a Startup: Investor’s Perspective
Venture capital firms have several sophisticated models at their disposal to value startups, including the scorecard valuation method, the venture capital method, the Dave Berkus valuation method, and the risk factor summation method.
We won’t go through all these approaches in detail here, but the following two general approaches are often used and are useful for founders to understand.
This is an important model to understand, as it is often used to calculate a starting point for deciding what a company is worth.
The idea is that investors won’t be willing to pay more than what it would cost to duplicate the business. This means that we need to account for all the costs that went into building the business to the point that it is currently at, to determine what it would cost to duplicate that business.
For example, if we are looking at a software business that has a minimum viable product, we need to calculate all of the development costs that went into designing and building the product to determine what it will cost to build a similar business.
Or if that business is still at the idea stage, we will look at what the cost to build the product will be and use that cost as a factor in determining the valuation.
The limitation of this approach is that it does not take into account expected future revenue.
To get to a valuation, we will also need to have a forecast of expected revenue.
Market Multiple Approach
This is a similar approach to what we discussed in the section Startup Valuation Methods: Revenue Generating Businesses.
The difference is that since we are dealing with pre-revenue startups we cannot use EBITDA or revenue figures, but must instead rely on forecasted revenues.
However, investors will still look at the average valuation of similar businesses and use that to determine an average multiple for businesses in that sector.
This multiple can then be adjusted downwards to take into account the risk that comes with investing in pre-revenue startup ventures.
For example, if you have a seed stage SaaS business with forecasted recurring revenue of £200,000 an investor might apply a 5x multiple (instead of a 10x multiple) to get to a valuation of £1,000,000.
Using these two methods will help you as a founder to understand what valuation investors will have in mind for your business and give you a good starting point when entering into negotiations.
MOHARA Can Help with Funding
MOHARA invests in seed-stage startups through our sweat equity model. If you are a startup with a great idea looking for a funding alternative to cash investment, we can help.
With over ten years of experience and software product expertise, we can help you grow your business exponentially by providing you with the resources you need to execute your ideas.
We love to partner with the right startups and help them to build out world-class technology.