The Venture Capital Pre-Money Valuation Method For Pre-Revenue Startups

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After taking on the Scorecard Valuation Method it's time to move on to the Venture Capital Method. Here's what you'll need to make it work:

I am an ardent proponent of the Scorecard Valuation Method for pre-money valuations when it comes to pre-revenue startups because of its simplicity and ease of use for both an entrepreneur and Angel. Yet, let us examine other valuation methods prescribed by top US Angel Investor, Bill Payne. Another highly used valuation method is the Venture Capital (VC) Method for pre-money valuations. To begin, let’s touch on the basic equation for a post-money valuation:

Pre-money valuation + Investment = Post-Money Valuation

So, if a pre-revenue startup had a pre-money valuation of 1 million€ and then received seed capital of 500,000€, the initial post-money valuation would be 1.5 million€. The angel investor here would have a 33.3% equity stake in the company based on the post-money valuation of 1.5 million€.

IMPORTANT: The angel investor would not have a 50% stake on a pre-money valuation of 1 million€, but a 33.3% equity stake based on a post-money valuation of 1.5 million€. This is a major mistake that entrepreneurs make.

In the Venture Capital (VC) Method of pre-money valuation, we work out the post-money valuation first and then ultimately find the pre-money valuation. This method has elements of Mergers & Acquisitions valuation components. We are going to stick with an initial seed investment requirement of 500,000€. Right now we are not going to consider convertible debt options and dilution from further equity financing rounds, to get the basic gist of the valuation method.

Post-money valuation = Exit value ÷ Expected Return on Investment

1. Exit Value is the expected price that the company would be sold for. As the startup in question here is in pre-revenue stage, we would have to depend on industry data to determine the exit value. One easy way is to find the average sales of established companies in the startup’s industry, and multiply the sales figures times a multiple of 2. This works well especially for tech companies. Let’s get an example for a biotechnology pre-revenue startup, using industry statistics from CSI Market’s industry data.

  • Estimated average sales of 5 small capitalization biotech firms = 50 million€
    • 50 million€ times sales multiple of 2 = 100 million€ exit value.

The other way is to find industry after-tax earnings multiply by an industry Price/Earnings Ratio.

  • Estimated earnings after tax of 5 small capitalization biotech firms = 6 million€.
    Industry P/E Ratio = 12

    • 6 million€ times 12 P/E Ratio = 72 million€ exit value.

In this example we use small capitalization biotech firms to stay away from ‘unicorning’ the valuation. As Bill Payne depicted, one can take the average of both exit values if need be. In this case, let’s go with the ‘quick and dirty’ exit value measurement of 100 million€.

2. Expected Return on Investment: Since at least half of startups fail, angel and VC investors must expect a high return on investment (ROI) from startups in their investment portfolios. Bill Payne suggests between 10X and 30X ROI, and added to this, preferably within a 5 year time frame. Let us expect a 25X ROI from our biotech pre-revenue startup.

3. Post-Money Valuation = 100 million€ ÷ 25X = 4 million€

4. Pre-Money Valuation = Post-Money Valuation – Financing = 4 million€ – 500,000€ = 3.5 million€.

And there we have it! We worked our way to a pre-money valuation of 3.5 million€ using the Venture Capital (VC) Method, knowing the initial investment requirement, finding the post-money valuation via industry statistics, estimating the ROI, and doing some basic algebra. Remember, the Angel’s equity stake in this instance will be 12.5% on the post-money valuation of 4 million€. The VC Method of pre-money valuation is very helpful for pre-revenue startups in industries that have sound statistics. It is a little more quantitative in data derivation than the Scorecard Valuation Method, which assigns multiples and percentages to a higher proportion of qualitative data. Angel investors tend to use multiple valuation methods to compare and decide upon a final startup pre-money valuation.

What about further financing rounds and dilution? Bill Payne suggests a method that is a bit unorthodox, but is very elementary and easy to do! If further rounds of financing are expected to create dilution of 50%, then reduce the current pre-money valuation by 50%. In this case, we would have a reduced pre-money valuation of 1.75 million€ to represent this initial seed round. In this case, the entrepreneur would need to have a clearer quantitative idea of further financing rounds needed in the pipeline. As with all estimates, remember to have the startup’s CEO and CFO get a qualified opinion before using the pre-money valuation. As with all valuation methods, the Venture Capital (VC) method provides a strong framework for internal planning and startup negotiating power.



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