Tips on how to determine your early-stage business pre-money valuation
Determining your company’s pre-money valuation can be challenging. It’s a combination of art, science, positioning, how quickly you need to raise capital, and many other variables.
Investors always want a good deal, and founders want to preserve their equity. Determining the right valuation requires assessing numerous factors and finding the right balance, as well as the right investors.
The following should help with how to think through and build a realistic, as well as defensible, valuation that reflects the value of your business – not just in your eyes, but in eyes of prospective investors.
To start, you need to objectively assess, evaluate, and score numerous variables related to your business.
Your Founder(s) and Management Team
Investors tend to back people and teams as much as they back ideas and products. The more experienced (particularly relevant industry and start-up experience) and the more successful your management team, the more highly prospective investors tend to regard, rank, or score your management team.
Is/are your founder(s) a known commodity? Has he or she successfully run a start-up company before?
Note: While a founder may have been successful in a corporate environment like Microsoft or Google or Amazon, it doesn’t necessarily translate success or expertise growing a startup/early-stage company. In fact, sometimes it’s just the opposite.
Is your team working full-time or part-time? The more dedicated the team is to the business, the more confidence it instills in investors.
Has your team invested money in the business? How much time have they dedicated to the business?
Investors consider your management team’s track record, experience, relevant expertise and commitment to the business. Not just in your targeted industry, but also their experience building and growing startups into commercially successful ventures.
Market Size
Quantify your TAM, SAM, and SOM to demonstrate that you’re focused on a lucrative market opportunity and hopefully in an expanding target market. Or maybe it’s a relatively small market size, but in highly underserved and lucrative niche market.
Investors always consider the size of the market, as well as its maximum and realistic growth potential when assessing valuation.
Market Opportunity and Competitive Landscape
It’s not only the size of the market that matters, but it’s how you use it – business intelligence that is! (Just checking to see if you’re still awake.)
Explain why ‘now’ is the right time for your business venture, i.e., are there significant technological, regulatory, timing, location, demographics, psychographic, or other market forces will help you seize and optimize the market opportunity.
Is this a “green field” opportunity with limited competition? Or how can incumbent players in the marketplace be leapfrogged? Do they have gaps in their offerings? Are their customers frustrated with their pricing or customer support? Do you have key partners / partnerships, unique technology or IP?
In essence, understanding not just the size of the market, but the competitive landscape, how you stack up to the competition, and how accessible the marketplace opportunity is versus the competition is critical to prospective investors.
So, it’s important to have competitive matrix or SWOT analysis that you can show prospective investors, to help them understand not only how your product stacks up to the competition, but ideally how you win – within your target market segment and with your target customer audience.
Remember to identify your unique differentiation, for example, IP, product features, customer loyalty, marketing strategy, economic model, partnerships, distribution channels and the potential impact they can have on your financial projections.
The Stage, the State of Your Product, and the Type of Product
Since investors are all about risk migration, where you are in the product life-cycle typically makes a huge difference. For example:
• Are you just at the ‘concept stage’?
• Do you have a solid product team and product roadmap?
• If it’s a physical product… have identified a manufacturer? Do you have pricing and manufacturing delivery timeframes?
• Are you in development and nearing completion your MVP product offering?
• Is the product demo-able?
• Have you completed your MVP and are you ready to go to market?
• Have you launched your product in “production,” i.e., is it live in the market.
• Are you beyond MVP with additional value-added functionality that resonates with your target audience?
• Has your product been live/in-the-market for a period of time? Is it demonstrating market/customer adoption, pricing adoption, and depending on the type of product, customer retention or loyalty?
Keep in mind that not all products are created equally. For example, SaaS product offerings tend to receive substantially higher valuations than service businesses. The same is true if you have a hardware product or a better hybrid, hardware-software offering with recurring revenue potential.
Additionally, when it comes to valuation, your market segment makes a difference. For example, a SaaS product offering in the Fintech, Martech, Edtech, Medtech, Biotech, Protech, etc., all tend to have someone different valuation ranges.
Another example of this is on Medtech and Biotech, where your product may be complete, but still needs to go through 1 or more years of medical trials and regulatory review before receiving commercial approval. The longer the approval cycle and the more uncertainty of receiving approval will impact your valuation.
Furthermore, some product offerings are targeted at consumers; others at businesses (either enterprise-oriented businesses or at SMBs); and some are marketplace product offerings (bringing buyers and sellers together).
Note that with enterprise-oriented businesses ‘the bar’ in terms of product adoption tends to be significantly higher on the product side, but it you have early-stage enterprise market adoption, that can significantly improve your valuation.
Also, some technology areas are hotter than others, for example, AI, ioT, Cloud Computing, Blockchain, Battery Technology, AR/VR tend to be in demand at the moment. Therefore valuations tend to be higher, and funding is often a bit easier in these areas (but necessarily – nothing is easy!)
In addition to a solid competitive matrix/competitive analysis, it’s important to also have product roadmap that you can share with prospective investors. This way they not only know where your product is currently, but where it’s headed, in what timeframe, and how it stacks up versus the competition.
Capital and Time Invested to Date
Investors always want to know and consider:
- How many people are on your team? (Which can cut both ways.)
- Is your team working full-time or part-time?
- Have the Founder’s invested money in the business? If so, how much?
- Have Friends and Family invested money in the business?
- How much time have the founders and team dedicated to the business?
- The amount invested in the business to date is a helpful data point related to valuation. However, how efficiently and effectively you’ve utilized funds to date is an equally important factor.
Product Traction, Revenue, and Product Unit Costs/Margins
As mentioned earlier, some of the most important criteria for investors are:
• evidence of market/customer fit,
• user/customer adoption / traction,
• evidence of pricing acceptance,
• customer testimonials,
• customer retention or loyalty, and ideally
• revenue.
Of course, businesses raise investment capital at all stages, when they are pre-product, pre-launch, pre-traction, and pre-revenue, and post revenue. However, customer traction and revenue significantly impact the business’ valuation.
Business Model and P&L Projections
When it comes to valuing your business, key factors are your business model and financial projections.
To really understand a business, a detailed financial model is essential to demonstrate that you have a solid understanding of the business and the key economic drivers/levers.
In fact, almost all of the other factors mentioned should be encompassed in your financial model.
A thorough, detailed 3 – 5-year, monthly, financial model covering (a) operating expenses, (b) marketing and sales expenses, (c) product development, (d) revenue, (e) net cash flow/profits, and (f) the timeframe and capital needed to reach breakeven helps build investor confidence.
Your financial model should showcase your company’s scalability, projected customer and revenue growth rate, market penetration and profitability. And of course, it must be realistic and achievable within the specified timeframes.
Your financial model is often used to compute the Net Present Valuation associated with your business, i.e., your business’ valuation. (More on this below.)
Industry Benchmarking
To “sanity test” and improve your financial model, look at companies in your industry with similar business goals, business models, growth rates, and customer bases.
Study recent fundraising rounds and acquisitions/exits of companies similar to yours. This gives you a sense of current market sentiment and investor appetite.
Use relevant valuation multiples related to your industry such as…
• Revenue multiples (e.g., 3X -5X ARR)
• Industry average or competitors’ costs of user/customer acquisition (e.g. $150 per active user)
Compare your business metrics to industry averages or competitors to help estimate a reasonable pre-money valuation or range.
Use industry data to sanity test your financial projections and valuation – and adjust based on your business’ strengths or weaknesses.
Calculate Your Business’ Net Present Value
Net present value (NPV) is used to calculate the current value of a future stream of payments or revenue from a company, project, or investment.
NPV is used in capital budgeting and investment planning to analyze a project’s projected profitability/ROI.
To calculate NPV, you need to utilize your financial projections which include the timing and projected amount of future cash flows, and you need to pick a discount rate equal to the minimum acceptable rate of return.
The discount rate may reflect your cost of capital or the returns available on alternative investments of comparable risk.
Applying a discount rate to your financial projections reflects the risk associated with early-stage investing (typically 20-40%, sometimes more).
Your discounted financial projections determine your business’ Net Present Value, which forms the basis of your computed business valuation.
Other Factors That Can Impact Valuation
Geographic Location of Investors
Often investors in different geographic areas will view the valuation of a company differently. For example, on the west coast, early-stage business valuations tend to be lowest as you go north and progressively increase as you go south, i.e., Vancouver BC (lowest) àSeattleàCalifornia (highest).
Understanding investors’ geographic investment tendencies can prove to be useful – particularly when seeking a lead investor.
Need/Urgency for Capital
Another factor that comes into play is how urgently your business needs the capital. The greater your urgency to get a deal done, the more likely you are to reduce your computed valuation to get a deal done quickly.
Capital fundraising takes time, so do your best to allow sufficient time to raise capital without putting yourself in a situation where you need to reduce your intrinsic valuation just to close a deal quickly.
Investor Negotiations
Of course, valuations and investments are not purely scientific, numerical or mathematical. Valuation is ultimately a negotiation.
The element of negotiation is sometimes a function of how compelling the founder presents the investment opportunity. It’s sometimes a function of the connection between the founder and an investor(s) or sometimes function of how many investors are interested in investing in your business.
When it comes to investor negotiations, know your must-haves, where you can be flexible, and where are your “lines in the sand”.
Market Sentiment
Understand how current macroeconomic trends, funding cycles, and investors’ outlook/sentiment affect valuations and benchmarks in your industry.
409A Valuations
Consider getting a 409A valuation. A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock. It is used to determine the strike price of a stock option, which is the price at which employees can buy company shares.
The 409A valuation attempts to provide an objective assessment of your company’s worth based on its assets, financials, growth projections and other metrics. It differs from a venture capital (VC) valuation, which focuses primarily on a company’s potential for high future returns. So, venture valuations can differ significantly from 409A valuations.
Final Thoughts
Determining your company’s pre-money valuation is a challenging combination of art and science.
To determine a realist pre-money valuation for your business, you need to blend an objective assessment of your company’s strengths, weaknesses, market momentum, market comps and benchmarks, financial projections, along with discounted cash flow analysis and net present value analysis.
How Can We Help?
Book a free 15-minute introductory capital fundraising strategy session with us and let’s chat.
