How to Determine the Value of Your Pre-Revenue Startup
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Good news: Despite the perception that we in the VC world employ armies of analysts working behind the scenes and prepping us to beat down the valuation expectations of poorly prepared entrepreneurs, nothing could be further from the truth.
Bad news: Much like trading baseball cards, there is no science to pre-revenue valuations. It all comes down to a negotiation. However, there are some basic guidelines for founders that can help both sides come up with a figure that works for everyone.
1. Understand valuation terms.
A pre-money valuation is what the company is worth before third-party dollars go into it. A post-money valuation is the value of the company plus those dollars at the time of investment. If you own a company that you and an investor value at $1 million, and he puts $1 million into it, the pre-money is $1 million, the post-money is $2 million, and you are now 50-50 partners. Comprehending this most basic part of the negotiation will ensure that you come across as knowledgeable and cannot be exploited by potential investors.
2. Acknowledge the 10x return.
To offset the significant risk they face when funding unproven startups, investors often start with a simplistic expectation that they should have the potential to see a return on their investment equal to 10 times what they put up.
For example, if you need to raise $1 million to get your company off the ground, and you believe it will be bought someday for $20 million, realize that your investors will want to see their $1 million investment turn into $10 million when you sell the company. This also means that your pre-money valuation can’t creep much higher than $1 million.
3. Consider other terms.
A startup’s initial valuation is only one aspect of a funding deal. If valuation discussions become a stalemate, then it’s possible to work around them. Founders can lobby for higher compensation and options in lieu of equity stakes; investors can fight for preferred dividends and treatment of their shares when it comes to another round of funding or a sale.
Remember, VC firms look for good transactions, not just good companies to invest in. Don’t blow their interest by being unrealistic about your valuation and demands. Better yet, show you have some sophistication by understanding how they make their money. Be creative.
Big purchases are negotiations that require give and take from both buyer and seller. Selling a chunk of your company to a VC is no exception.