Fundamentally, valuing a startup is very different than valuing an established company. Financial projections don’t always predict the startup’s future success, which is why some angel investors put greater value in the entrepreneur and management team. Potential investors would like to understand the competitive environment and risks, as well as risk mitigation strategies, including the entrepreneur’s knowledge of the business environment and ability to run the business. Depending the conviction, the investor can determine the value to place on the startup and how much to invest if at all. There is no one way to determine, the startup’s value before receiving outside investment, (the pre-money valuation). No matter the 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 This method compares the startup to other similar funded startups modifying the average valuation based on region, market, and stage. This is to determine the average pre-money valuation for pre-revenue 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 is on the team. The quality of the team is paramount to success. A great team will fix early operational challenges, but the reverse is not true. Lastly, calculate the percentage weights.
Venture Capital (VC) Method
This method determines the pre-money valuation after first determining the post-money valuation using industry metrics 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.