As an entrepreneur seeking to raise funds, you probably know that startup valuation often relies on guesswork and estimation, so there’s no single, universally accepted analytical methodology for investors. Instead, venture capitalists and angel investors draw upon several venture capital valuation methods to understand the value of a startup.
The use of startup valuation methods is dependent upon the stage of your business and the corresponding data points available in your startup’s market and/or industry your startup operates in (earnings/revenue/acquisition multiples etc.).
In this article, we’ll take you through the 4 most commonly used early-stage and pre-revenue angel and venture capital valuation methods to help you understand how potential investors may assess your business.
In the meantime, if you’d like an idea of what yours might be, use our startup valuation calculator.
- Venture Capital Valuation Method
- Scorecard Valuation Methodology
- Dave Berkus Valuation Method
- The Risk-Factor Summation Method
1. Venture Capital Valuation Method
The VC Valuation Method was first introduced in 1987 by Harvard Business School Professor Bill Sahlman. It can be used by venture capitalists and angel investors to work out pre-money valuation by first determining post-money valuation, using industry metrics.
The methodology is simple and stems from the following equations:
Post-money valuation = terminal value / anticipated ROI
Pre-money valuation = terminal value / post-money valuation
Let’s take a closer look at what each of these terms means:
- Terminal value is the anticipated selling price of your company at some point in the future – assume 5 to 8 years as the average for early-stage equity. The selling price can be estimated by establishing a reasonable expectation for your revenues in the year of sale and, based on those revenues, estimating your earnings in the year of the sale.
- Anticipated ROI is the projected return on investment for your company’s investors. All investments must demonstrate the possibility of a 10-40x return (as per industry norms for early-stage investments).
How does the Venture Capital Valuation Method work?
Let’s put the Venture Capital Valuation Method into practice using the example of a SaaS company with revenues of £20m upon exit.
They might expect to have post-tax earnings of 15% or £3m. Using available industry-specific price to earnings (PE) ratios, a 15x PE ratio for our SaaS company would give an estimated terminal value of £45m.
As investments must demonstrate the possibility of at least a 10x return, we’ll assume an anticipated ROI of 25x for this example. So,
Post-money valuation: £45m / 25x = £1.8m
Assuming our SaaS entrepreneur needs £500,000 to achieve positive cash-flow and will grow organically thereafter, the pre-money valuation of this transaction is:
Pre-money valuation: £1.8m – £500,000 = £1.3m
What if there is a need for subsequent investment? An easy way to adjust the pre-money valuation of the current round is by reducing this by the estimated level of dilution from later investors.
If this sounds a little complex, don’t worry. We’ve created an interactive startup valuation tool that does these calculations for you – all you have to do is answer the questions.
2. Scorecard Valuation Methodology
The scorecard startup valuation method compares your company to similar angel-funded startup ventures and adjusts the average valuation of recently funded companies in the industry to establish a pre-money valuation of your startup. Such comparisons can only be made for companies at the same stage of development.
How does the Scorecard Valuation Methodology work?
Step 1 – Determine the average pre-money valuation
A venture capitalist or angel investor will determine the average pre-money valuation of pre-revenue companies in your business sector. Pre-money valuation varies with the economy and the competitive environment for startup ventures within an industry. In most industries, for pre-revenue startups, the pre-money valuation does not differ too significantly from one business sector to another.
Based on Seedrs’ data, as of 2019, pre-money valuations vary from £750,000 to £2m for seed stage, pre-revenue companies.
Step 2 – Compare your company to similar deals in your sector
The next step is to compare your company to similar deals done in your sector, considering the following:
- Strength of the founder and management team: your experience, skillset, and flexibility as the founder, and the completeness of your management team.
- Size of the opportunity: market size for your company’s product or service, the timeline for increase (or generation) of revenues, and the strength of competition.
- Your product or service: product/market definition and fit, the path to acceptance, and barriers to entry.
- The quality of your business plan: the sales channel, the stage of business, the size of the investment round, and the need for financing.
Here is a section of a typical valuation worksheet that has been developed to assess the relative strength of target companies:
Step 3 – Score your startup and calculate its value
You will see that for each comparison factor, like the one shown above, there are a set of multiple-choice questions to answer about your business. The answers give your startup a score in the range of -3 (worst) to +3 (best).
An angel investor or VC would multiply this score against the comparison factor range (see below) to give each section a weighting, then sum up the total factors and multiply this against the average pre-money valuation for your industry to arrive at your startup’s estimated valuation.
3. Dave Berkus Valuation Method
Dave Berkus is a widely respected lecturer who has invested in more than 80 startup ventures. Dave’s model first appeared in a book published by Harvard’s Howard Stevenson in the mid-1990s and has been used by angel investors ever since.
The most recent version of the Dave Berkus Valuation Method updated in 2009, would start with a pre-money valuation of zero, and then assess the quality of your company in light of the following characteristics:
|Characteristics||Add to Pre-Money Valuation|
|Quality management team||Zero to £0.4 million|
|Sound Idea||Zero to £0.4 million|
|Working prototype||Zero to £0.4 million|
|Quality board of directors||Zero to £0.4 million|
|Product rollout or sales||Zero to £0.4 million|
For example, if your early-stage business has a good quality management team, a working prototype and sales, your valuation will be estimated at £1.2m following the Dave Berkus method.
Note that the numbers are the maximum for each class so a valuation can be £800,000 (or less) as easily as £2m. Furthermore, Dave reminds us that his method “was created specifically for the earliest stage investments as a way to find a starting point without relying upon the founder’s financial forecasts”.
4. The Risk-Factor Summation Method
The Risk-Factor Summation Method considers a much broader set of factors in determining the pre-money valuation of pre-revenue companies. The Ohio Tech Angels who developed this method, describe it as follows…
“Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘management risk’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types.”
The most important risks that need to be assessed include:
- Management risk
- Stage of business
- Legislation/political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each of the above risks is then assessed as follows:
| very positive for growing the company and executing a lucrative exit|
negative for growing the company and executing a lucrative exit
The average pre-money valuation of pre-revenue companies in your industry is then adjusted either positively by £200,000 for every +1 (+£400,000 for a +2) or negatively by £200,000 for every -1 (£400,000 for a -2).
For example, a business with no manufacturing risk (+£400,000), no legislation risk (+£400,000), no reputation risk (+£400,000), low competition so positive for growing the company (+£200,000), but potential management risk (-£200,000), will be valued at £1.2m.
Founders should use a combination of these methods
In summary, good practice suggests using at least three startup valuation methods to estimate the appropriate pre-money valuation of your company.
If all give roughly the same number, simply average the three. If one is an outlier, then average the other two or, alternatively, use a fourth method in an attempt to bring three of them into close agreement.
For more information, check out our comprehensive guide The art of startup valuation: A guide for early-stage and pre-revenue startups.
Use our startup valuation calculator
Are you interested in raising funds with Seedrs?
We are the UK’s most active and dynamic investor, with our services rigorously put through their paces by hundreds of founders every year. Apply to raise with Seedrs now or get in touch to discuss your fundraising plans in more detail.