How Angel Investors Value Pre-Revenue Startups (Part II)
Venture Capital (VC) Method
Recently, we discussed how angel investors value early-stage startups without existing revenue. In particular, we examined the Scorecard Valuation Method. Angels have found the Scorecard Valuation to be effective by placing greater emphasis on certain qualities such as the management team and market opportunity. However, when valuing high-risk investments, it’s best to measure by the quantity of something rather than its quality.
“Best practice for angels investing in pre-revenue ventures is to use multiple methods for establishing the pre-money valuation for these seed/startup companies. The Venture Capital Method is often used as one such method.” — Bill Payne, Frontier Angel Fund
In a series of three posts I’ll be sharing three pre-money valuation methods often used by investors. Below, in the second installment, we’ll review how investors determine pre-money valuations by applying the Venture Capital Method.
Venture Capital (VC) Method
The VC Method, first made popular by Harvard Business School Professor Bill Sahlman, works its way to pre-money valuation after first determining the post-money valuation using industry metrics. By applying the VC Method to solve for the pre-money valuation of a startup it’s important to know the following equations:
- Post-money valuation = Terminal value ÷ Expected Return on Investment (ROI)
- Pre-money valuation = Post-money valuation — Investment
We will use these formulas to ultimately work out the pre-money valuation, but first we need to find the terminal value. The terminal value is the anticipated value of an asset on a certain 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. For the purposes of this example, we’ll be solving for the pre-money valuation by using two separate exit multiple approaches.
Approach 1
By researching the average sales of established companies within the same industry (at the end of the projection period) and multiplying the figure by a multiple of two, we can calculate the terminal value. For example, lets assume your startup is raising $500K and expecting to be generating $20M when you sell the company in five years.
- Terminal Value = $20M x 2 = $40M
The statistical fail rate for angel investments is over 50% so investors typically target 10x-30x ROI on each individual investment. To be conventional, we’ll set the anticipated ROI at 20x for the pre-revenue startup. Knowing you’re raising $500K, we’ll then work the math backwards to calculate the pre-money valuation.
- Post-money valuation = $40M ÷ 20x = $2M
- Pre-money valuation = $2M — $500K = $1.5M
Approach 2
The Price/Earnings ratios ( P/E ratio) could also be used as the multiple for valuing your pre-revenue startup. If your expected after-tax earnings are 15% upon exit in five years, this leaves you with $3M ($20M x 15%). Then you need to multiply this value by the P/E ratio which is backed by industry benchmarks of similar public startups. Lets say the P/E ratio is 15x with the same expected ROI of 20x.
- Terminal Value = $3M x 15x = $45M
- Post-money valuation = $45M ÷ 20x = $2.25M
- Pre-money valuation = $2.25M — $500K = $1.75M
Investors typically calculate both multiples and take the average of the two. Therefore, the pre-money valuation of your startup is roughly $1.625M. This is a very simple introduction for entrepreneurs to the VC Method as I did not account for multiple rounds of investment and anticipated dilution. If future rounds of funding are expected to create dilution of 50%, then reduce the current pre-money valuation by 50% to $812,500.
“The valuation will also be reflective of the type of investor you can get on board.” — Thomas Britton, Co-Founder of SyndicateRoom
By using the anticipated value and ROI, we’ve worked our way backwards to a pre-money valuation for your pre-revenue startup. The VC Method is definitely more quantitative than the Scorecard Valuation Method. Inputs will vary across verticals and industries so I recommend experimenting with VCMethod.com’s spreadsheets to achieve what you’d believe to be optimal outputs for you and your investor(s). The VC Method is not only a good route to determine pre-money valuation, but also for systematic planning of future rounds of investment.
Other Recommended Valuation Methods:
- Part I: Scorecard Valuation Method
- Part III: Berkus Method
