5 Actionable Ways To Value A Startup With No Revenue
By Lior_Ronen | Founder, Finro Financial Consulting
I think you'll agree with me when I say:
It's tough to value a startup, and it's even more complicated when it hasn't generated a single dollar in revenue.
Lucky for us, there are specific methods that we can apply to estimate the value of a startup with no revenues.
So, if you're interested in:
The reason we even need startup valuation for pre-revenue startups.
Using the most common quantitative methods for early-stage startup valuation.
Building a comparables valuation for a pre-revenue startup.
Analyzing previous deals for our benefit.
You'll love what we got for you. So without further ado, let's dive into my favorite pre-revenue startup valuation methods.
Why Do We Need Startup Valuation?
The main question in every new topic we face is why we need it. This is a great one since it helps us understand the essence of our issue.
In this case, we'll tackle the "Why" first by understanding what a startup is, what a startup valuation is, and finally, what it is used for.
The combined information for these three questions should highlight the real need behind a startup valuation.
What is Startup valuation?
A startup is a newly established business.
The number of startups in the US has constantly increased since the world financial crisis.
In 2021, nearly 5.4 million applications were filed in the US to form new businesses — the most of any year since 2005.
Startup valuation is, unsurprisingly, the value of a startup company.
A startup valuation should consider every factor that impacts the business, niche, market, or industry directly related to the company.
Usually, when valuing a startup, we look at:
How the company generates revenues and acquires users?
Can we identify any traction around the company?
Are users satisfied? Do they leave the service quickly or stay for a long while?
What is the growth potential of the startup?
How do other deals in the niche impact the startup we're valuing?
A good startup valuation should take all of these into account.
New startups' valuation has increased since the 2009 financial crisis and peaked in 2021.
Why Do We Need To Know The Value of A Startup?
A startup founder can finance a new business venture in one of three ways:
Taking money from other people (angel investors) by selling off parts of the company to them.
Taking on debt.
Investing their own money.
When a founder sells equity of its company to investors or takes on debt, investors would need to know how much the business is worth for three main reasons:
To understand how much they should pay for the stake they want to buy.
To determine future conversion and liquidity terms.
To estimate future return.
Investors use a variety of methods to estimate a startup's value. They translate the different aspects of the business into a potential valuation of the company.
However, different startups require different approaches and business valuation methods.
So how can I know which startup valuation method I should use in my case?Let's start by breaking down the term startup.
The definition of a startup is fragile and delicate.
A startup is a new business initiative started by a single founder or a few co-founders.
The startup's primary goal is to develop a new business idea or technology to solve a specific problem.
We can categorize startups according to their stage of the business or the revenue generation status.
In the early stage of their lifetime, typically in the seed rounds, series A and series B are early-stage startups. Startups that are in a more mature funding round are late-stage startups.
Startups that haven't generated revenues yet are typically called pre-revenue startups and startups that already generate revenue are post-revenue startups.
The diagram on the right shows the intersection of these terms.
Post-revenue startups and pre-revenue startups can be either early-stage or late-stage. In most cases, an early-stage startup will be pre-revenue, and a late-stage will be post-revenue. But there are many exceptions to this tule-of-thumb.
So far, we have laid the ground for a pre-revenues startup and why I need to know its value. Now, we can discuss the top-5 methods to estimate a pre-revenue startup's valuation.
There are several methods, and we'll focus here on the most popular and valuable ways.
When building a startup's valuation, we base it mainly on projections and growth rates, especially when that startup is pre-revenue.
Since we have very little data to work with, we can use a qualitative or quantitative approach.
The Qualitative Approach
The term Qualitative Approach to valuation is a puzzle.
How can we put a price on a business in a qualitative way? The whole purpose of a valuation is quantitative.
In fact, for some businesses and in some stages, potential investors rely more on their gut feeling than on any quantitative calculation.
In this approach, investors grade different aspects of a business and translate these grades into a rough valuation number.
This section covers the two most commonly used qualitative valuation methodologies: the Berkus Method and the Payne Scorecard Method. These are two different valuation methods, but they have a lot in common as they use a subjective grade system to estimate a startup's valuation.
1. The Berkus Method
Dave Berkus initially introduced this method in the 1990s to simplify early-stage startup valuation.
The method allows early-stage investors to value a company without a thorough financial analysis and due diligence.
It allows investors could quickly assess a startup's value simply by grading different aspects of the business subjectively, without analyzing financial statements, reviewing financial metrics, or spending too much time digging in legal documents.
To produce an estimated company valuation with the Berkus Method, investors grade each aspect of the business below. Each grade will increase or decrease the final result.
This method is for startups that investors believe will generate at least $20M in revenues in the next 5-years.
If the answer is yes, they should use the Berkus method.
Here's a quick guide to value a business based on the Berkus method:
If Exists: Add to Company Value up to:
1. Sound Idea (essential value, product risk) $1/2 million
2. Prototype (reducing technology risk) $1/2 million
3. Quality Management Team (reducing execution risk) $1/2 million
4. Strategic relationships (reducing market risk and competitive risk) $1/2 million
5. Product Rollout or Sales (reducing financial or production risk) $1/2 million
This method is flexible and assumes a maximum $2.5M valuation for a pre-revenue startup. This value can change according to the average valuation of seed and pre-seed deals in the specific niche or location.
2. The Payne Scorecard Method:
Bill Payne introduced this method in the early 2000s.
Like the Berkus model above, the scorecard valuation method also requires potential investors to grade different aspects of the business.
Each element has a different weight, and the overall aggregated factors are multiplied by the average valuation of similar companies.
Strength of the Management Team 0x - 0.30x
Size of the Opportunity 0x - 0.25x
Product/Technology 0x - 0.15x
Competitive Environment 0x - 0.10x
Marketing/Sales Channels/Partnerships 0x - 0.10x
Need for Additional Investment 0x - 0.05x
Other 0x - 0.05x
Total startup valuation 0x - 1.0x
When "x" is the average valuation its peers received in their earlier fundraising.
The Quantitative Approach
The quantitative approach to pre-revenues startup valuation includes different methods that to estimate a company's value based on financial estimates.
This section covers three primary methods: the venture capital method, the comparables multiple method, and the previous transactions multiple method.
3. VC Method
The venture capital method was introduced by Harvard Business School's professor Bill Sahlman in 1987.
This valuation method is more common amount venture capital firms that invest in the early stages. This method looks at business valuation from a different angle than the other methods. It starts from a post-money valuation of a potential lucrative exit in the future. It removes layers of valuation until we get to the current pre-money valuation of the startup.
Step 1: What is the estimated exit value for the company? i.e., $450M
Step 2: What is the ROI (return on investment) the investor expects? i.e., 15x
Exit Value / ROI = post-money valuation i.e. $450M / 15 = $30M
Step 3: What is the amount invested? i.e. $3M
Post-money valuation - the amount invested = pre-money valuation before dilution. i.e., $30M - $30M = $27M
Step 4: What is the estimated dilution? i.e., 45%
Current pre-money valuation before dilution (1 - estimated dilution %) = pre-money valuation after dilution. i.e., $27M (1-0.45) = $14.85M
4. Comparables Multiple Method
The comparables valuation looks at the market value of a company by comparing it to other companies in the same sector.
Comparables valuation is one of our favorite valuation methods. It is a model that you can use to value every business, whether it’s a seed-stage startup or an established company.
This method uses the revenue multiples of comparable companies like competitors, market leaders, and startups with a similar business model.
We can value every company based on other financial elements that we can project.
We can value pre-revenue startups by combining comparable companies' revenue multiples with the startups' projected revenue.
This method combines two data sets: the company's revenues forecast and the comps analysis.
Step 1: Building the revenue forecast
Each company has a different way of forecasting its future revenues.
There are two main approaches to revenue forecasting: bottom-up and top-down.
The bottom-up sales forecast is ideal for startups with a clear business model and requires significant data and a set of assumptions.
To build a bottom-up sales forecast, we must first estimate how many clients the company will have in the next three to five years. Then we must calculate how much each client is likely to pay each month or year
Our run-through bottom-up sales forecast guide is here to learn more.
The top-down sales forecast approach looks at the company's sales forecast from the macro level.
This method starts from the top, with the total available market ('TAM') size, and moves down to the company level.
Our full step-by-step guide for building a top-down sales forecast is here to learn more.
Once we have our revenue forecast, we need to calculate the average annual revenues.
We prefer to do it with a weighted average where the early years receive higher weight and later years receive lower weight since accuracy probability dops with time.
Step 2: Building the comps analysis
Comps analysis, also known as the comparables analysis or competitors analysis, is the backbone of the comparables valuation.
When building our comps analysis, we prefer to use a combination of public and private companies.
However, some information can be hard to find online without access to a paid service.
To build the comps analysis, you first need to prepare a list of potential companies that should be considered.
These companies can be your peers, direct competitors, partners, clients, suppliers, or any company with a similar business model.
To avoid being swayed by the performance of a single company, include enough companies in your analysis.
The next step is to gather the trailing twelve months (TTM) revenues and valuation for each one of these companies in the list.
Information about privately-held companies in our list is the hard part of the research.
However, you can mostly gather the info through press releases, media articles, or paid platforms specializing in private companies' data like Capital IQ, Pitchbook, or PrivCo.
Step 3: Calculating valuation with the comparables valuation
Once you've assembled a list of 20-25 comparable companies, you can use revenue multiples to determine each company's revenue. Then add up all the companies' revenue multiples to get the total revenue multiple of your valuation
We will begin by dividing each company's enterprise value by its trailing twelve months or latest annual revenue to compute the enterprise value-to-revenue ratio.
Next, we will combine the multiples from each peer group into a single total. Then, we will calculate an average of the multiple values.
An arithmetic mean gives equal weight to each comp but does not account for relative importance.
A weighted average enables us to give more or less weight to specific comps and emphasize aspects that are most relevant to our analysis.
Last, we'll multiply the overall revenue multiple with the annualized revenue figure we calculated in step 1 above.
5. Previous Transactions Multiple Method
This method is very similar to the comparables multiple method, but we're using data from previous relevant deals, not general multiples.
Some of this information is confidential, and we will not have access to it. However, in other cases, we could use publicly-available data about the deal, like company announcements, for example.
We need to gather two data sets to evaluate a startup using previous transactions: deal sizes and annual revenues.
Deal sizes are usually published in the press release when the participants announce the deal.
In most cases, the deal's announcement will not include the entire deal terms but only deal sizes. Therefore, annual revenues will be published separately from the deal announcement and possibly in previous or later media publications.
Like in the comparables method above, it could be tricky to obtain some of the previous transactions' information. If the data is not available, you can find it in paid-private market platforms like Pitchbook or PrivCo.
For Conclusion
This post covered the top 5 ways to value a pre-revenue startup with qualitative and quantitative methods.
There are other valuation methods that I haven't covered here since they don’t fit pre-revenues startups. Such as the discounted cash flow (DCF) that caculate the business’s value based on its future cash flow, the risk factor summation method (RFS), price to earnings and more.
In this post I preferred to focus on the startup valuation methods that are most popular among venture capitalists and founders a fit pre-revenue startup specifically.
What do you think?
Which method do you prefer when valuing a pre-revenue startup?
Do you have anything to add that we didn't cover?
Leave a comment below to let me know.
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