How is a pre-revenue startup rated
Before financing: This is how you rate your startup correctly
Often founders get laughter or even horrified expressions in front of the investors in the lion's den exactly when they are asked to answer what percentage of their start-up they want to give away for how much money. Too often founders are wrong about the value of their startup. Therefore, here are instructions and critical tips on how to properly evaluate your company.
Classic company valuation & suitability for startups
A number of classic procedures for evaluating a company have emerged, these are
- the discounted cash flow method (equity method and entity method)
- the multiplier method (e.g. sales, EBIT (DA), book value)
- Benchmarking (e.g. comparison of balance sheets and financial ratios based on industry leaders)
- as well as the VC method
Depending on the phase, these procedures are only suitable to startups to a limited extent. Financial planning is based on assumptions, particularly in the early phase (i.e. in the phases in which “proof of concept” and “traction” are often missing) or in the preseed phases and early early-stage phases. This is not unlike “painting by numbers” in an Excel sheet. Comprehensible and logical assumptions should be chosen here, which can be convincingly and plausibly presented to the potential investor.
Benchmarking as an option for startup evaluation
In fact, benchmarking is the best way to evaluate your startup. Comparable companies with a similar business model and that are in a similar corporate phase are used as a comparison value. This works on the basis of "multiples" - e.g. x times sales or x times EBIT (DA) or x times number of customers taking into account the “Unit Economics” in a B2C business model.
Pre-money or post-money rating and the relevance for your rating
Pre-money valuation is the company valuation before the capital increase, post money valuation is the company valuation after the capital increase.
An example: I am looking for € 1 million for my startup and will give up 20% of the company's shares. The pre-money valuation is therefore € 4 million - i.e. before the € 1 million is received. The post-money valuation, on the other hand, then amounts to € 5 million (after receipt of the € 1 million).
The more percentages given to company shares, the greater the difference between the valuation indicators for company valuation.
BUT CAUTION: Often the pre-money valuation cannot be calculated from the post-money minus the investment amount because part of the capital was used to buy out individual shareholders, so-called secondaries, or convertible bonds at a different valuation level are included in the financing round. Or options, employee participation programs and differently designed share classes (e.g. due to diverging liquidation preferences) and the shareholder structure distort the result.
Venture capital method and its dangers
The VC method is used to determine the company value of a startup before the entry of a VC investor, taking into account the liquidity result at the exit from the investor's point of view.
This is how the rating is calculated: For the VC method, the company value is calculated back from the planned exit proceeds (using a multiplication method based on the business plan / financial plan of the start-up in combination with industry-specific transaction indicators) when selling or going public. The return expected by the investor (IRR / internal rate of return method in a wide range, often from 20% to 80%) is then calculated depending on the risk assessment between the time of entry and the sale. By calculating compound interest based on the investor's expected return, the future value of the investment is then determined upon exit. The final stake is then calculated by dividing the future value of the investment by the future enterprise value of the startup.
The Risks: With the VC method, a number of assumptions are made and this also represents a great deal of uncertainty. Who knows, especially with early-stage startups, how they will develop over the next 5 or even 7 to 8 years. Who knows which valuation multiples and transaction ratios will prevail in certain industries depending on the market phase in the future. The choice of the IRR (Internal Rate of Return) depending on the risk assessment of the business model can also be chosen very arbitrarily, at least within a certain range, etc.
The VC method thus serves to provide a further point of reference and orientation and, in combination with discussions with investors, can show the possible evaluation within a certain range. It is advisable to play with the assumptions within certain bandwidths in order to get a feeling for this calculation, to follow a corresponding chain of arguments for the assumptions and results in order to gain a basic understanding of this method. However, it is and remains just a calculation method that leads to completely different results depending on the choice of assumptions.
Compare with the great founding successes
Startups like to compare themselves to big startups: “We are the AIRBNB among FinTechs”, “In three years we will be the Amazon for feminine hygiene products”. Is that even possible with the valid assessment?
Well, to explain the business model in one sentence, you can partially, but mostly (often better) without this analogy. With regard to the evaluation, the comparison of different industries is not representative, as each industry is subject to its own evaluation standards and peculiarities. In addition, there are always "hypes" for various industries, i.e. a so-called "window of opportunity" (see e.g. Blockchain, VR / AR, KI), which are played for a while and sometimes allow irrational (evaluation) surcharges.
Correct Approach to Startup Assessment: Conversations
An evaluation is always the interplay of supply and demand. Therefore, you should speak to as many investors as possible to get a feel for what you are worth with different investor groups (BAs & HNWIs, VCs, CVCs, family offices).
In addition, the distinction between strategic and financial investors is blatantly important. In the case of a strategic investor, a rapid increase in value through further development is possible when this occurs, already through valuable contacts, possible sales channels or future orders, and thus a lower valuation is common for this investor.
A short how-to of self-assessment
When evaluating your startup, you should adhere to the following: As much as possible, on the other hand as little as necessary, so as not to complicate the whole thing unnecessarily.
- A financial plan with at least the forecast for the next 3 years (better 5 or even 7 years) should be the basis of your self-assessment.
- Then you can calculate all the methods. The balance sheet and income statement form the basic requirement, cash flows should also be modeled.
- Do not make it too complex in discussions if you present the calculation to experienced investors, as the assumptions can be discussed excellently.
On the other hand, you learn a lot with every internal modeling that is carried out and can therefore discuss more with investors on an equal footing. Here we observe significantly high information asymmetries between professional, qualified investors and founders of startups.
You need these key facts and figures from your market
Basically, a rapidly growing market, in which you are also well positioned, is of course much more attractive in terms of valuation than a stagnating or saturated market. However, this basically says little about your business model, your market opportunities and ultimately your evaluation.
Instead, try to show "bottom-up" how you can be successful in your market and how you plan to gradually gain market share.
Concrete discussions with customers or even first LOIs or MOUs that lead to new customers and sales in the next three, six, nine and 12 months and thus realistically show the successful market entry or market growth are much more relevant and convincing.
With the (market) numbers of competitors you can show how you differentiate yourself and, if necessary, position yourself better. Or you can also show the immense market potential that is already being used successfully by your competitors.
Here you get key facts and figures
Figures for the overall market are available, depending on the industry, including forecast and market growth, from the large research institutes (e.g. Technologie Gartner), from the large consulting companies (e.g. McKinsey or BCG), and also from the large auditing companies ("Big Four").
Figures from other, similar companies, especially startups that are not listed on the stock exchange, are mostly not published publicly. Here you can, depending on the type of company and headquarters of the startup, possibly (indirectly) pull figures from the commercial register and electronic federal gazette of comparable companies.
This is how you set up a valid calculation
A valid, objective evaluation should be the goal, but it is actually a paradox, since there is only the supposedly valid evaluation between two parties. In other words, in addition to all of the above-mentioned evaluation methodology, which provides a point of orientation (and which you should have calculated and can show that you have mastered it!), A deal comes about between two people / parties and there are a lot of factors that determine (personal preferences , game theory negotiation skills, sales strength, synergies, sympathy, consultants and lawyers, investor structure, etc.).
Basically, the investor and the founder work together towards one goal and it should be clear to all sides what is brought in and required by both sides and must be anchored in writing in the company and investment agreement. The entire corporate finance keyboard can and should then be used there. Here can also be very good at Calls (purchase options) and Puts (put options) work, which may be used depending on the milestones reached or missed.
You can present that to the investor with a clear conscience
After signing a nondisclosure agreement (NDA), we recommend presenting everything to the investor. Of course, it is important that you determine the context, i.e. the environment in which your numbers and analyzes are embedded. This is how you can highlight strengths and opportunities.
But please do not try under any circumstances to be the “clever part” at the table, who willfully hide things or make things overly optimistic. In the long term, it's about making the startup big together and not about adding € 500,000 more or less to the valuation.
You are “in the same boat” with the investor and can only be successful together. The basis for this is a deal that is fair to both sides and the most congruent goals possible - especially with heterogeneous investor structures with regard to, among other things, term and return expectations as well as exit strategy.
You can find more information and explanations of terms here:
More about Key Person Discount
More on discounted cash flow methods
More on the top-down approach and bottom-up approach and terminal value
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