Genius’ Dilemma: Valuation Of A Pre-Revenue Startup
By: Howard Lubert
Tags: Angel Investors, Private Equity, Investing, Entrepreneur, Valuation

Is it the task of a financial genius? Simply put, an angel investor’s task is to calculate the value of a pre-revenue company before a company receives your investment. There is a delicate balance between the entrepreneur’s objectives seeking funding and the expectations of an investor providing capital. After three decades in this space, I contend that it is more of an art than a science; however, with company equity on the line, all parties want to ensure that critical value drivers are considered. This article highlights some of the methods and elements that are covered in my investor workshops.

Critical drivers of valuation include tangible and intangible. Common factors used in assigning value include but are not limited to the management team, the business assets, innovations in technology, and market climate. At the end of the day, valuation is a core determinant of investors’ and shareholders’ expected return.

In my opinion, the management team’s strength and skill have a significant weight in the valuation model. We refer to this as betting on the jockey, not the horse. There are many examples of a strong entrepreneur with a proven team, skill diversity, and commitment that have brought a mediocre idea to market success. There are far fewer stories about a mediocre entrepreneur and team getting a great idea to market success. The experience and skill to navigate the pivots and foibles of growth needed to refocus the company as required deserve the proper consideration.

In a field of rapid technological innovations, it is important to understand, monetize, and defend intellectual property value fully. The due diligence needs to determine a value based on the scope of patent protection, restricted covenants, trademarks, copyrights, and trade secrets. With a patent, it can become more complicated when the IP is licensed. In the last decade, valuations have also considered brand recall, domain names, and social media accounts containing a measurable value.

For a tech startup based on software development, a smart investor should consider the duplication cost when assigning value. It may be as simple as calculating the total cost of programming time that has gone into the software, or it could be more complex factoring in the time to replicate any unique components such as algorithms or proprietary calculations (that may be patent protected). Unless the software has a specific feature or function that is patentable, the valuation needs to assess competitive market entrants’ risk.

As measured by early adopters and sales channel partners, market interest is an important factor in valuation. The ability of a company to attract a customer base and grow with a small investment demonstrates potential. The company’s value can reflect a higher assessment based on attracting customers and partners with a relatively low acquisition cost.

There is no one magic formula to calculate the pre-money value. The more startups you analyze and perform due diligence on, the more you define how to measure these factors. Depending on where you look and whom you talk to, you may be pointed to more than a dozen valuation models. This article will focus on just four of the most commonly used by angel investors in early-stage deals.

Ø Berkus Method, developed by Dave Berkus

This method assigns monetary values from $ .00 to $ 500,000 to 4 key indicators that reflect an early indication of business success. There is also value given for the quality and potential of the business idea. The value grows as the strength of these factors grows. It should be noted that this valuation model has a cap of $2.5M and was designed for very early-stage companies. It was initially developed in 1990 and was updated to reflect market developments in 2009.

Ø The Venture Capital Model

This model uses an estimate of Post-Money Exit Value to calculate the current Pre-Money valuation. The first step is to use historical data to estimate the expected exit value after a given number of years and expected revenues. The second step in this model is to factor the Exit Value ROI. Since most VCs target a 10x return; that is what was used in the example below.

This model effectively backs into the pre-money valuation and has been used for decades.

Ø Money-in Method, developed by Howard Lubert

A simple and effective way to determine the starting point of the pre-money negotiations is to divide the pre-money ask by the company’s total invested to date (including all non-dilutive funds). This will provide an X factor. For example, if the pre-money ask is $10M, and the company has raised $250k to date, the formula will deliver a 40X factor. In the realm of normalized valuations, this number should almost always be a single digit. A single-digit expected return at this stage makes sense and demonstrated consideration on the entrepreneur’s part.

When a company is anticipates a round of financing, it will have to negotiate its pre-money valuation with investors. It can be an intense and subjective negotiation. However, the intention is to bring an entrepreneur and an investor together in setting up an environment of shared success. If you are negotiating on behalf of yourself and you are not investing the total amount the company requires, you will have little negotiating power. There is always strength (and control) in numbers so, whenever possible, the pre-money negotiation should be done on behalf of all the investors for the total anticipated raise the company requires.

As you progress through your investing career, you will develop skills in identifying areas of risk and success factors. I strongly recommend working with an experienced angel investing group to expedite your learning. An angel group will also allow you to collaborate with other investors to bring different experiences and expertise to the table.

It’s not always the genius who makes the optimal investments, but the diligence put in by the team that reaps the greatest rewards.

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The author:

Howard Lubert, Founder Keiretsu Forum Mid-Atlantic, South-East, and Accelerator Venture Partners Fund

Howard Lubert continues to build upon a strong foundation of successes in angel investing, which began while at Safeguard Scientifics. In his career working with early-stage companies, Howard estimates that he has seen over 10,000 pitches across every business silo. His experience working as a Fund Manager and as a private angel investor gives him an exceptional vantage when assessing new deals.

In 2010, Howard founded Keiretsu Forum Mid-Atlantic. “Keiretsu” is the Japanese word for a family of affiliated companies that form a tight-knit alliance and work toward each other’s mutual success. Consistent with this definition, Keiretsu Forum is a conglomeration of serious investors, business leaders, venture capitalists, corporate & institutional investors and serial entrepreneurs bound by overlapping and co-dependent goals to work together for each other’s mutual benefit, form strategic partnerships, enhance each other’s knowledge and build an angel network of diverse skills.

For additional information, go to www.KeiretsuForum-MidAtlantic.net or email info@keiretsuforum.net.