How I value pre-revenue startups

First, a disclaimer: This is soft science and there is more than one right answer. But, there are definitely wrong answers as well. I’ve had to navigate through the maze of startup valuations a few times, and I learnt that business is not done on spreadsheets.

I often get asked by entrepreneurs what I think their ideas (!), inventions, businesses or companies are worth. Valuations can lead to difficult, uncomfortable conversations and negotiations should be postponed until after the due diligence if possible. Assuming the company passes the DD, here is how I do it:

How much do they need?

The average South African tech startup needs few assets but will have expenses of R50k — R200k per month at the onset. On paper, the amount of money that they need is equal to the cumulative loss until breakeven is reached. I recommend raising slightly more than the breakeven amount, because life happens and raising the next round sooner than anticipated is distracting and expensive.

Entrepreneurs tend to underestimate the amount of investment that they need. One of my brutal DD techniques is to half the projected monthly revenues, postpone all revenue by two months, and add about 25% to all expenses. If the business survives this test, it is either a great opportunity or the numbers were grossly misjudged.

How much equity do I prefer?

In the seed stage, entrepreneurs should definitely have the majority shareholding. This keeps them motivated and leaves room for next rounds. If there are virtually no assets in the business and the company needs R2M to get going, the investor(s) could get 40%, valuing the company at R5M post investment. Some people would argue that R3M is then given to the entrepreneurs “for free” because they brought no assets into the company. If you think that entrepreneurs benefit unfairly in this scenario, why not start your own business? There is a good reason why we have a shortage of competent, energetic young people who are willing to quit their careers and take on massive personal risk and pain to start a business. The personal and professional cost is huge and these people are scarce. When I find them, I incentivise them.

Net Asset Value

Assets and liabilities are indicators of value, but NAV is not a one-stop solution. Do not fall into the trap of valuing assets, especially IP, at what they cost. Liabilities, which are usually loans, are easy to handle. Ignore them, do your valuation, then subtract the loan amounts from the valuation. Depending on the repayment terms of course.

What will it cost to replace the business?

Although money spent to date offers little indication of the value of a business, I sometimes ask myself what it will cost to replace everything in the business. The dilemma with this approach is that you cannot buy time or people. It takes time to build a product and good entrepreneurs are not for sale.

Quality of the team and investors

Yes, investors are human! The valuation of companies with proven entrepreneurs and sought-after investors deserve higher valuations. But that’s only because their probability of succeeding is so much higher.

Stumbling blocks

  1. Emotional entrepreneurs. Entrepreneurs are sometimes emotional about valuations. This can complicate negotiations and doom very promising businesses.
  2. The amount of money that has gone into the business. Although this must be considered, not every expense adds value to your business. If it cost you R5M to build a company that can produce solar-powered electric toothbrushes, it means you spent R5M and you have assets that can hopefully generate income. It cannot be assumed that there is someone out there who will pay you R5M for that company.
  3. Previous rounds. These usually put immovable pegs in the ground that act as a non-negotiable minimum valuations.
  4. Looking too far into the future. Sometimes, entrepreneurs will meticulously calculate their valuation based on a detailed 36+ month financial model. In a pre-revenue phase, it’s hard enough to predict what will happen 3 months down the line and it is impossible to know what will happen 3 years from now. Anything more than 12 months and you’re pushing it.
  5. Nationalities. Entrepreneurs and investors from different nationalities have different norms and expectations. This can also stifle negotiations on valuations.

Hope that helped!

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