Startup Investing 101: How to Value Pre-Revenue/Early Stage Companies
A business that is just starting out might not appear to have any value for those who don’t share or understand the founder’s vision about the product or service and its future profitability.
However, how much would you have paid to buy 1% of Amazon when Jeff Bezos was working out of his parent’s garage? Or how many shares of Apple would you have bought from Steve Jobs if he pitched you the idea of a personal computer?
The success of many out-of-a-garage companies has been the most influential force behind the rise of angel investors around the world, with wealthy individuals now tirelessly searching to discover the next Microsoft or Netflix.
That said, how do you value a firm that is just an idea? How much value do you place on a prototype? You can begin answering these questions by understanding three different methods through which investors can value a startup or a pre-revenue business.
The Cost-To-Duplicate Method
The cost-to-duplicate method estimates how much it would cost to replicate the business at its current or future stage to calculate the value of a startup.
These costs would include legal fees, research and development costs, hours invested by the founders to push the business to its current stage, and other similar disbursements that would have to be assumed by a prospective competitor to build the same business from scratch.
The benefit of the cost-to-duplicate method is its simplicity. However, the overly simplified nature of this method often neglects the value of goodwill that comes with an idea that has the capacity to disrupt an entire industry.
Fixed Value per Stage
The fixed value per stage method consists of assigning businesses a fixed value based on the stage they are at in the business development cycle. The amounts assigned for each level might vary from one industry to the other but the scales tend to be rather similar.
Here’s an example of how a fixed value per stage method would look like:
· Idea stage - $1,000 to $50,000: the company is only an idea in the mind of the founder.
· Idea & team stage - $50,000 to 100,000: the business has a strong team with the right background to possibly push things forward once they have the capital they need.
· Prototype stage $100,000 to $1,000,000: the founders have come up with a tangible product or service that is ready to be marketed.
· Proof of concept stage - $1,000,000 to $5,000,000: the company has a network of suppliers and distribution channels that have embraced the product or service.
· Startup stage - $5,000,000 to $25,000,000: the company is already generating revenue and it is progressively growing.
People who know their way around venture capital and startup investing like to stay in the loop when businesses within their area of expertise raise money. They love to dig into the details of the funding round to get a sense of how much others had been willing to pay for a business that generates X revenue or is at B stage in the business development cycle.
The reason for this is that this kind of information can help value future startups they will be investing in in the future by using a method known as peer comparables.
A peer comparable is in essence a valuation multiple assigned to a company that is multiplied by its annual revenues, number of users, number of downloads (for apps), or EBITDA.
To assign a multiple to a startup by using this method, angel investors look for similar deals that have been made by other venture capitalists and they use a similar multiple to value the deal at hand.
Finding the next Apple or Amazon is not as easy, nor without risk, so knowing how to value these once-in-a-lifetime opportunities is crucial. It also helps investors determine how much is appropriate to offer founders for coming up with such great ideas.
Although the list of methods provided in this article seems rather short, prospective investors can implement the three of them combined and compare the results to see which one reflects the more appropriate value to the investor of a given project.