Early-Stage Pre-Revenue Startups Valuation? Yes We Can!
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
Every business, in every stage can be valued. In some cases, valuation is more straightforward and in other cases valuation is more challenging.
The most important element when building an early-stage startup valuation is to optimally reduce the effect of the optimism bias and survival bias on their financial forecast and valuation.
There are number of ways to do that.
In this post we’re covering 3 ways to reduce the bias and produce high quality valuation for early-stage and pre-revenue startups.
In the last few years since I founded Finro, many early-stage startup founders asked me if there's a way to value a pre-revenue startup. They usually have two significant concerns. The first one is that they don't have any historical sales figures to base their forecast on. The second is that they either view the valuation as a mysterious black box that spits out a magic number or has a distinct idea of the valuation they believe is fair but have no idea how to justify it.
Every company can be valued no matter how much money it makes, how complex its legal structure, and what stage it is in. However, since valuations are based on founders' expectations and their subjective point-of-view of how successful their product/service will be, they are naturally biased towards over-optimism concentrated on the businesses that made it and survived throughout time. In behavioral economics, these effects called survival bias and optimism bias.
To develop an accurate valuation as possible, we need to optimize the effect of the optimism bias and survival bias on the outcome. We have several ways to do that.
1. Valuation Range
In early-stage startups, where historical financials are limited to nonexistent, there is a significant weight to the founders' subjective expectations. Naturally, as founders, they will be optimistic and believe that their product will have a remarkable adoption rate and phenomenal clients and sales growth rates.
To mitigate this inherent optimism, we use the founders' revenue and user base forecasts as the best-case scenario, and together with the founder, we come up with specific assumptions that we could stress to show the worst-case scenario. In some cases, we even build more potential scenarios to show how financial performance fluctuates when the underlying assumptions change.
Each scenario of the financial projection will then be translated into a different valuation of the business. When dealing with late-stage, pre-IPO, or mature companies in this stage, we would come up with some mechanism to drive a single number for the business valuation. However, since there is minimal certainty how an early-stage startup will develop after launch, we will use a range of the highest and lowest results and the valuation range of the business.
Private Market Investing
The investing universe includes two parts that exist in parallel and intersect on some occasions: the private and public markets. Public market investors benefit from liquidity, structured processes, easy access, and low transaction costs. However, in the private market, the upside potential in many cases higher than the public market, although it is significantly harder to access and success.
2. Wide Range of Comps
The conventional take on comparables is either using publicly traded companies that their business resembles the valuated company in some aspect or using sector averages of public companies. Both of these sets of comps are great because they can provide a significant amount of data that is useful for the valuation, but it feeds the survival bias that skews the valuation.
To mitigate the survival bias created by using public companies' data, we add private companies' data to the comps mix. In most cases, this is not as easy as adding public companies' data since information can be hard to find and might not be available even on platforms like Pitchbook or PrivCo. Still, it could add a precious insight from the private market that is more relevant to the valuated company than public companies comps.
Learn more about Finro’s valuation services >>
3. Previous Transactions
Probably the most useful piece of information for early-stage valuations is the price and multiples of previous deals in companies that are either direct competitors with the valuated company or have some similar business aspects.
In some cases, founders that I worked with wanted to use previous deals' information that is based on anecdotes rather than on reliable data. Since this is an essential piece of the puzzle and will be challenged, the information on previous deals must be credible and based on actual data such as certified docs, publications, or reports that could be obtained and share if needed.
Previous deals information is a broad term and can include different ratios that can help with the valuation when the most popular are EV / Revenue, EV / EBITDA, EV / Total Amount Raised. Still, I've also seen other ratios that are specific to their industry.
Additional read: Ins & Out of Startup Valuation
Final Notes
Valuating pre-revenue early-stage startups might not be as clear and evident as valuating startups in more mature stages, but it could be done. In Finro, we complete these types of valuations every month, for both early-stage startups and investors.
Since we work with investors and startups from all over the world, it is essential to note that requirements vary between locations, countries, geographies, and cultures. Something that worked for a startup in Utah might not work for a startup in Singapore. No one solution fits all.
Need a valuation for a pre-revenue early-stage startup? You can shoot me an email or drop me a DM.
