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Methods for Valuation of Seed Stage Startup Companies
This post was written by Bill Payne in conjunction with Angel Capital Association.
Much like the real estate market, the starting point for determining the valuation of seed stage ventures is comparable deals. At what valuation have similar deals at the same stage, in the same business segment and in your region been funded recently? Knowledge of local recent transactions is key to establishing the valuation of the target company. And, it is important to acknowledge that the valuation of startup ventures changes with competition (lots of capital chasing deals in a given business sector increases median valuations) and with the business cycle (angels are less likely to open their pocketbooks during a deep recession, driving down valuations).
Having pointed out the obvious, it is also useful to have several valuation methodologies in your tool box to provide a rational basis for determining reasonable pricing. Angel investors have found four methods that are particularly useful for determining the pre-money valuation of pre-revenue companies (with customer valuation and at the cusp of first revenues). And, at the outset, early stage investors seldom find discounted cash flows based on proforma financials to be particularly useful. Entrepreneur-provided financial projections are simply too imprecise for reliable analysis.
Why do we need four methods? There are no scientific methodologies for establishing a valuation for early stage ventures. Better practice dictates that we use multiple methods for estimating the valuation for investment purposes, then based on those results chose a final pre-money valuation (by averaging multiple methods, perhaps after eliminating outliers).
Venture Capital Method
Developed by Professor Bill Sahlman at Harvard Business School in the 1980s (HBS Case #: 288006-PDF-ENG), the VC Method described practices of venture capitalists in valuing early stage deals. A simplified version of the method has been described here: Venture Capital Method. This tool requires the estimation of the eventual selling price of the company (5-8 years hence), which is then divided the investors anticipated ROI to arrive at a current valuation. A rough method of accounting for dilution due to subsequent investors is covered in the linked article and described more elegantly by Professor Sahlman in his case study.
Dave Berkus Method
Long-time member of the Tech Coast Angels, Dave Berkus, describes this method in his blog at The Berkus Method: Valuing an Early Stage Investment. Dave attributes a range of dollar values to the progress startup entrepreneurs have made in their commercialization activities, the sum of which becomes the valuation of the company (pre-money valuation). You can find my analysis of The Dave Berkus Method at this link. Note: The maximum valuation possible using Dave’s method is currently $2.5 million (giving full dollar credit for each activity). In competitive markets, it might be necessary to give each category a bit larger range to enable somewhat higher valuations. That said, I think Dave’s methodology is quite useful to early stage investors.
I’m told that the Scorecard Valuation Method is perhaps the most popular among angel groups in the U.S. This method adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company. The specific details are described in the link above. Note: The linked article was written at a time when the median valuation for deals in the US was lower than today. See my recent post for a discussion of the median pre-money valuations for pre-revenues companies in 2012 (a consensus of $2.6 million).
Risk Factor Summation Method
This method compares the 12 characteristics of the target company to what might be expected in a fundable seed/startup company and is described at the following link: Risk Factor Summation Method. This method is useful because it requires investors to consider a much broader set of characteristics of seed/startup ventures than other methods. Like the Scorecard Method, this method adjusts the median pre-money valuation for companies in similar business verticals and in your region based on your perspective of the 12 characteristics of the target company. However, since all categories have the same weightings (considered by some a flaw in the method), I would recommend using this method with at least two other methods before making a final decision on valuation.
There is no perfect methodology for establishing the pre-money valuation of pre-revenue seed/startup ventures. Consequently, investors are advised to use multiple methods to arrive at a final valuation, four of which we’ve outlined above. . You’ll find that some methods will be more applicable to specific ventures than others. You may choose to change the ranking, characteristics or weightings of activities described in a given method to better fit a target company. And recognize that using three methods, as an example, will give you three answers: you might find that all methods give you similar results, widely different results, or that one method yields an outlier. Think carefully about the three outcomes and use a rational approach for selecting a final number.
Final word: Using multiple rational valuation methodologies does not preclude other investors from offering a term sheet with a much higher valuation. Your choices then are (1) bite the bullet and invest at the higher valuation or (2) pass on the deal.
Bill is has been actively involved in angel investing since 1980. He has funded over 50 companies and mentored over 100. Bill is also a founding member of four angel organizations: Aztec Venture Network, Tech Coast Angels, Vegas Valley Angels, and Frontier Angel Fund.