How Pre-Revenue Companies are Valued?

Valuation of any company can be a very complex task. However, when it comes to pre-revenue companies, this complexity is magnified. This is because of the fact that valuation is generally the discounted value of the future cash flows which are likely to arise in the future. The current cash flows are used as a base to project future cash flows. However, when it comes to pre-revenue companies, there is no current cash flow. Hence, the projection of future cash flows can be considered to be speculative in nature.

The business of startup financing requires investors to routinely invest in pre-revenue companies. It is for this reason that investors have come up with several methodologies which are used in such valuations. Some of the commonly used methodologies have been listed below:

1. Simple Iteration: The most simplistic and least used method of valuing pre-revenue startup companies is called simple iteration. This method assumes that once an investment has been made in a start-up company, no further investments will be made. Hence, the basic assumption is that the percentage of the company which the investor holds will remain the same from the investment stage to the exit.

   Hence, the valuation is done by simply compounding the investment at an agreed-upon rate. However, the valuation of startups is almost never so straightforward. Investors invest in startup companies because there is a high prospect of growth in the near future.

   However, a high prospect of growth also means that the company will have to raise funds from external sources. Since dilution is equity is almost imminent for any reasonable startup, this method is not considered to be appropriate for valuing them. However, this can form a theoretical basis to demonstrate a hypothetical base case scenario.

2. Terminal Value: Another method for estimating the value of a pre-revenue company is to use the terminal valuation method. The terminal valuation method does not take into account the cash flows during the life of the firm. Instead, the terminal value method focuses on estimating the revenue of a company during the last year of the investment horizon. Once this revenue is known, investors can use two ratios to find the value of the firm. These two ratios are the net profit margin and the price-to-earnings ratio.

   For instance, if the revenue of a firm in the final year of investment is $100 million, we can use industry averages to make an approximate guess of what the net profit will be for that particular firm. If the industry average is 20% net profit, then we can assume that the firm will make $20 million in profits. Now, the price-to-earnings ratio can be used to value the firm. If it is common for firms in that industry to have a price-to-earnings ratio of ten, then the firm can be valued at $200 million based on the $20 million which the firm has in the form of profits.

3. Anticipated Return on Investment: The anticipated return on investment method is often used in conjunction with the terminal value method. This is done to find the post-money valuation of a firm in the immediate future.

   For instance, if the terminal value of the firm is estimated to be $200 million and the investors want to earn a 20× return on their investment, then the post-money valuation of the firm has to be $10 million.

   Hence, 20× is the anticipated return on investment which is used in conjunction with the terminal value in order to derive the post-money valuation. Now, a 20× return may seem to be predatory. However, it is common in the startup financing universe. This is because startups are inherently very risky. About 50% of the startups that investors back end up losing all or part of the money. The investors have to recover the losses from the ones which actually do make money.

   It also needs to be understood that if the value of the firm is going to increase by 20×, then the value of equity may or may not increase by the same amount. Dilution of equity is common and hence the investors may actually realize a much lower rate of return when they actually exit the business.

4. Investment Multiples: The use of investment multiples is also very common. Using this practice, it is common for investors to value firms using their assets as a base. The valuation multiple is derived by studying the values of similar companies in similar industries.

   For instance, investors might find that for a certain type of business, the value of the firm is 10× the asset base. Investors may find it challenging to ascertain the future revenue of a company. However, they may find it relatively easy to ascertain how much money the company is likely to have tied up in assets. This number can then be multiplied with the industry multiple in order to obtain the valuation of the firm. This method does not provide very accurate results. However, it is often used when it is not possible to use the other methods for one reason or another.

Investors commonly use one or more of the methods which have been explained above. It is also common for investors to have a totally different methodology which they have developed using trial and error over many years.