How Do Investors Value Pre-revenue Companies?

Deciding how to value pre-revenue companies is hard. There are many signals to process, and even after you’ve taken all of them into account, the final estimate is as much art as science. Deciding how much a startup should be worth is like deciding how much a one-of-a-kind painting should be worth: there are guidelines to move you in the right direction, but in the end you’re basically making an educated guess. What’s worse, you don’t truly know if your guess was good until long after you’ve made the investment. Despite that bleak disclaimer, there are heuristics for calculating the value of a startup – even one that has yet to make a dollar in revenue.

First, let’s start with a few thought experiments. For each thought experiment, let’s pretend you’ve been approached by a startup called ShopBetter, a company focused on improving shopping for buyers and for retailers, and you have the opportunity to acquire a 10% stake in the company. Your goal is to determine how much that 10% should be worth.

Thought Experiment #1: Founding Team

ShopBetter was founded last week and the founders know they want to improve shopping, but they haven’t decided exactly how they’ll do that. However, they are committing to work on something together for at least the next 5-10 years.

Thought experiment #2: Traction and Expected Near-Term Revenues

ShopBetter recently released a service that lets retailers learn more about their customers. ShopBetter’s business proposition is that richer demographic info will help those retailers promote and target their products more effectively.

Thought experiment #3: Growth and Engagement

The team at ShopBetter has been busy and launched a mobile app 3 months ago. Based on your research of similar shopping apps, you think a typical user’s lifetime value (LTV) will be about $2.

Additionally, user engagement is important. 100k users who log in monthly are not as valuable as 50k users who each use the app for 20 minutes per day.

Thought experiment #4: Market Size

You’ve analyzed the market for ShopBetter’s consumer app – the one where each new user is worth $2 in revenue – and have come up with a realistic estimate of the max number of consumers ShopBetter can expect to acquire.

Thought experiment #5: Competition

You’ve take a good look at ShopBetter’s founding team, its 100k app downloads so far, and its market potential, and now you turn your focus to the competitive landscape.

These thought experiments are meant to show how different attributes contribute to the value of a company. (The numbers are meant to be illustrative, not exact.)

In addition to these factors, there are other things at play when determining valuations:

Market forces and comparables are especially potent. Oftentimes, a founder will look at what valuations their friends are raising at then pick a number out of thin air. Then they offer that price to several investors, and if investors don’t push back, that becomes the final price. 

The way that I approach valuations – and I’m speaking for myself and not for other partners in my fund – is to first look at comparable companies to get a baseline value for a company. I then try to make reasonable adjustments for exceptionally good founding teams, markets, products, or growth/usage metrics. In the end, I come up with an estimate that I can compare to the estimates of my partners. If our estimates are in a narrow range then we’re satisfied; if they’re wildly different then we scrutinize our individual assumptions until we’re on the same page.

On final note, valuations do matter, but exact valuations do not. The average return of an angel investment is 2.6x over 3.5 years, and it’s okay if your valuation estimates are off by 5-10% once in a while. (An average, well-diversified portfolio should return about 2.6x, and 90% of that is still a healthy return). For a professional fund, the goal is to have better than average returns (e.g. 4x or 8x), and in that case the quality of companies that you invest in becomes more important than your ability to calculate their valuations to the nearest dollar.

(This was originally an answer on Quora.)

Tags: Valuation
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