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What pre-money valuation method to use for pre-revenue start-up?

We are a pre-revenue start-up and are actively seeking investments to take our prototype to the next level.

From my research, I hear that VCs expect a start-up to make ~50 million in revenue by year 5 for it to be a viable investment opportunity for them. However, an average pre-revenue start-up is usually valued at around ~4-8 million.

With the first 5 year revenue of 50 million, how does one justify a valuation of just ~4-8 million? We plugged-in our numbers into a basic DCF analysis and even with the most conservative capex/opex estimates, our valuation came out quite high. What am I missing?

Is using DCF for pre-revenue start-ups a good idea? Are there any other methods that Angels/VCs usually use?

Also, what is a typical "Discount Rate" that is reasonable for a pre-revenue pre-money valuation for DCF analysis? We used 12 to 14% for our analysis.

Thanks!


23 Replies

Vincent Harris
2
0
Vincent Harris Entrepreneur
Entrepreneur, Filmmaker, CEO at Hoozip, Inc.
I don't claim to have the answer to your question as valuation of pre-rev co's is more art than science. I can tell you that DCF is an inappropriate method for a business at such an early stage. DCF assumes consistency of cash flows. Ramping up the discount rate, no matter how high, cannot offset a complete lack of real cash flows to plug into your model. At this early stage of your business, may be better to use some sort of intrinsic value approach, i.e., value of the founders investment of time/money times some multiple. If you have real IP, i.e., patents there's a way to value that too. But I think you will lose credibility with a sophisticated investor if you whip out a DCF on a company that $0 earnings.
Tim Scott
0
0
Tim Scott Entrepreneur • Advisor
President, Lunaverse Software
I'm not an expert on how VC's think, but I have some guess. The crude math is this:

$50 million 5 year revenue x 10% chance of success = $5 million valuation

Never mind discount rates. This assumes a binary result of $50 million or $0. It also assumes that the $50 million makes it to net cash flow. So we're already high. Also, the 10% is of those startups that actually get funded. Of all the startups that pitch, the rate goes down to, what, 1%? So the value of an unfunded pre-revenue startup is like, well, nearly nothing.
Manav Choksi
0
0
Manav Choksi Advisor
Chief Operations Officer

Unfortunately, calculating the valuation for a pre-rev startup isn't as simple as a DCF. In fact, from my research, most pre-rev discount rates range from 30-50% as there are no positive cash flows to support a less risky investment. Mitigating factors include market cap, patents, etc. but these are difficult to incorporate into a DCF model. Given the early-stage nature of your startup, you may want to consider a family and friends round, in case you haven't already. Angels are also a great source of investment as they tend to focus more on the team, product, market size, and user traction, all of which are easier to determine at the current stage.

I'm not sure if your analyses included various models outside of DCF, but the following link appears to have more complex models which may prove useful. You would probably want to calculate the valuation using as many applicable models included herein to create a range for your valuation.

http://vtknowledgeworks.com/sites/all/themes/vtknowledgeworks/files/Valuation_Models_for_Pre-Revenue_Companies.pdf

Karl Laughton
4
0
Karl Laughton Entrepreneur • Advisor
VP of Finance at Insightly
Venture rates of return to reflect execution risk of a pre-revenue start up are 40-50%, adjust your discount rate accordingly.

The most relevant method for you should be precedent financing comps... find a competitor and back-channel to understand what the pre-money valuation on their last round was. Then figure out how fast they're growing, what their operating metrics roughly look like, and how you compare to them. Apply a premium or discount to the pre $ based on that bench-marking and you'll have a defensible story to lean on.


Robert Clegg
8
0
Robert Clegg Entrepreneur • Advisor
Game Based Learning Expert
Hi Shubham - this is going to be very blunt, some may consider it rude, some may see it as painfully helpful. If this is not the kind of input you are looking for, just skip this reply.

First, you say you've done your research - that's b.s. If you really had you'd know you aren't even close to the answer to this problem. In terms of meta-feedeback, you have a huge blind spot. You've assumed your approach to this problem is the correct one and therefore only find answers you were looking for. The answers to this question is all over the internet. You just haven't looked or searched for it correctly. Go find it. This makes me suspect any other aspect of your business from competitive research, to any number of things.

Second, I can only assume you don't have the right advisors on board. This is a basic question that at a minimum experienced advisors should have been able to answer in 10 seconds. Go get real advisors.

Third, you aren't involved in a local startup community or startup program. This is super basic stuff for startups; presentations, meetups, and workshops abound.

Fourth, your assumptions about what vc's are looking for is WAY off. And I don't mean numerically necessarily.

Fifth, doesn't sound like you have real legal representation with a track record of working with startups. If you did, ...

Sixth, I'm guessing you haven't raised friends and family. It's only a guess because if you have, I'm wondering how your legal time hasn't had discussions with you about how you bring in angels. And I'm wondering how you handled the valuation question there in the friends and family round. There are tons of legal firms that make presentations on this stuff.

Seventh, valuation is determined by competition and bidding. You think you are going to argue numbers with a vc? they only thing they respond to is competition for your company. a deal that's going to get way if they aren't on board. If no one else wants you it doesn't matter what your spreadsheet says. They just walk away.


So - Get involved in your startup community, get a real legal team for startups, get real advisors, raise friends and family. This should save you 2-3 years of floundering around.

sorry if I assumed things you might already be doing. don't focus on that. I hope something here was helpful. Don't take it personal. Good luck.



Sanjeev Makker
0
0
Sanjeev Makker Advisor
Assistant Vice President at Symphony Teleca
pumping up the discount will not help since you have to justify such a high rate while defending your financial assumptions and that can backfire....the bench mark rates needs to be a combination of risk free rate + risk premium / compare the discount rate with some of your competitors...i would urge you to try our scenarios pessimistic, optimistic and normal and use the discount rate accordingly.....that will be far more reasonable to defend and justify...

A 50 mn valuation would be only if you idea is like a twitter or FB...try angel investors or go to other VC's..if your idea has an IP,value that as well, may be your teams, or technology that you are using...etc...try using the probability method....

there is no right and a perfect answer....use two methods and see if you can arrive at a valuation between the two methods...which is more tenable...
Steven Vargas
10
0
Steven Vargas Entrepreneur
Product Manager at Hipmunk
VCs absolutely do not use DCF for early stage valuations. Projected cash flows have no meaning when you have no revenue today. You would not be taken seriously by even mentioning DCF as a valuation method.

Instead, valuations are more like housing prices in SF. They keep going up because of the market more than anything. Now having said that, here's how investors (not all are the same obviously) think of valuation:

1) Ownership
Most early stage VCs target a % of your company they want to own. That % will depend on a few things. For example, for industries that will require significant capital in the future, they may want to own more today. So they think of it as: How much money does the company need to get to the next stage? How much do I want to eventually own based on the potential of the company?
The target ownership is determined mainly by looking at the amount they stand to make if your company is wildly successful vs the size of their fund. Most will like to have the chance to earn their entire fund back with one big winner. They may invest more to get to that ownership level (giving you a higher valuation) if they believe you can get to a big exit.


2) Market/signaling
Most VCs look at the market rate for valuations, and make more of a binary yes/no decision. So, they ask "Do we like this company?", and then say "The market valuation for a company in this industry at this phase is $X." They know that if they don't adhere to the market, and instead only invest at lower pre-money valuations, then they will lose out on most big winners. VCs are under pressure to deploy capital, and would rather overpay for a company that could be a 10X winner than underpay for a company that they don't believe in.
It also is a signal to the market if company A has a pre-money valuation that is below its peers. Some VCs will stay away. It's like if you tried to sell a car for well-below market value. It signals that something is wrong with the car.

3) Competition
Really, this is the one factor that really affects valuation. You may think that having better traction, or an innovative business model will affect your valuation, but it doesn't. At least not directly. Not in some way that affects discount rate or anything. What those things will do is put your company in a position where more VCs will say yes to "Do we like this company?" and "Do we believe this company can get to a big exit?". This will bring you more offers, and that is the biggest factor in valuation.
Here's a way to look at it: Most YC companies immediately have a 25%-50% higher valuation just because they graduated from YC. This is not because these companies have higher cash flow projections than non-YC companies. It's because VCs know that there will be competition to invest in these companies because many have a track record of future success.
Now having said that, you can negotiate pre-money a little based on factors unique to your business that make an exit size bigger than industry norm. That will give you some bump in early stage valuation, but not as much as competition.

4) Future rounds / dilution
The last point is that, as a founder, it's great to have a high valuation. But be careful of having a valuation that's too high or too low. If you're valuation is too high today, during the next round of financing, you put yourself in a position for a down round. This is a bad signal to investors and the market. Earlier investors will likely be diluted more than they'd like, and likely not participate in future rounds.
On the flip side, if you set the valuation too low, and you try to raise a large amount of capital, then you dilute yourself more than you'd like. VCs (and founders!) don't like the founding team to be diluted too much. It makes it tough to raise money later, as investors don't want to put money into a situation where the founders don't have much skin in the game.



So to summarize, valuation isn't set by looking at future cash flows or anything. It's set by what VCs expect to make if you are successful, which sets the market rate for your stage company in your industry. Deviations from that are based slightly on your specific metrics vs others, but mainly valuations change due to competition for investment in your business. If you try to negotiate valuation with a VC, they will likely pull other levers in the term sheet to give them advantages elsewhere.

Rahul Harkawat
0
0
Rahul Harkawat Advisor
Entrepreneur with skills in building companies and creating value.
You could research angelist for comparable too Rahul "A leader is a dealer in hope." Napoleon Bonaparte
Steven Vargas
4
0
Steven Vargas Entrepreneur
Product Manager at Hipmunk
Robert, you are blunt! But also very right. Shubham, a few things to consider:

First, the fact that you want to take your prototype to the next level and are looking for VCs is somewhat off-base. Typically, you'll want to raise some earlier money than VC money (F&F or Angel).

Second, I don't know where you heard that VCs expect a startup to make $50M in year 5 and calculate valuation accordingly. What pre-revenue investors want is that you are uniquely solving a problem in a big market, that the solution can scale, and that you have the team that can execute. What has driven the pre-money valuations so high are: huge exits by companies like Instagram and more invest money than ever.

Third, here's where the $50M annual revenue comes into play. VCs want to know that your company can be worth hundreds of millions some day in the life of their fund. If you show that in 5 years or 10 years, you will be at $2M/yr, then your company will not have an exit that will make them their fund back. For them, future revenue projections are a checkbox that you can potentially be big. Next question is whether they believe you will get there.

Fourth, the idea that you can plug projections into a spreadsheet to determine valuation is way off base. There are far too many factors and risks. It doesn't matter what discount rate you use. You don't have any revenue today. Every VC pitch has the same hockey stick graph, and yet 98% of startups go broke. There's no discount rate that can accurately project valuation.

Fifth and finally, valuations are subjective and non-linear. Your company is worth what the market will pay for it. But you also have to consider that you have to get over the "Yes" barrier to be worth anything. Think of it like salaries in sports. The best players in the NBA will have huge competition from teams and make a ton in free agency. If you're not quite good enough to play in the NBA, teams will pay you $0. Same for startups. If you're 1/2 as attractive to investors as a funded company, it doesn't mean you will have a pre-money valuation 1/2 of there's. Instead, your valuation will be $0. So focus on getting in the NBA. Your salary will be determined by how many teams want you.
Michael Brill
0
0
Michael Brill Entrepreneur
Technology startup exec focused on AI-driven products
Robert Clegg, not everyone who asks a single naive question is a moron. Coming at the question of valuation from a DCF perspective is a pretty rational approach for someone who hasn't had a lot of exposure to financing a startup... and even if you google around, you'll see it as a popular approach for venture valuations, even if we all know it isn't. But Shubham may have such an awesome product and team that nobody gives a shit whether he's spent enough time understanding deal structures.

I don't disagree with the general sentiment of finding some local founders with fundraising experience... just the dispiriting, over-the-top bludgeoning.

Steven paints a great picture of how investors think about valuation. The only challenge is to have a principled ask and usually comparables are the easiest way to do that. e.g., the uber for chicken nuggets company just raised at a $4m pre, but your uber for fishsticks is a much larger opportunity and you have Ms. Paul and Mr. Gorton on your advisory board so you're looking for a $6m pre (oh, and by the way, you've got a friggin awesome DCF model to back it up!).

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