For a pre-revenue startup, calculating a startup valuation can be confusing and challenging. From the founder’s point of view, they have an awesome idea, a minimal viable product and some traction – and if you ask them, their app has the potential to serve millions of users and create billions of dollars in revenue. Ask a potential investor to evaluate the same startup, and they may see an unproven revenue model and a startup team that has little to no experience.
In the early stages, a startup’s true value is likely somewhere in the range of: lower than what a founder hopes it to be, and higher than what an investor is hoping to pay for a portion of equity. When revenue is not in play, there are many other factors that become more important to calculating a fair startup valuation, and many of these factors can be quite subjective.
What are these factors? When it comes to a pre-revenue startup valuation, what do investors look for? How do you secure an investment for your startup when you haven’t yet produced any sales? In this post, we want to find the answers to these questions and show you everything you need to know to prepare the best startup valuation when seeking investment.
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Why Is Valuing A Startup So Difficult?
Negotiations between an investor and a startup can be tense. On one end, founders approach the situation hoping to raise the largest amount possible while offering the lowest amount of equity. On the other end, investors are looking for the best deal – invest the least amount of money and receive the largest percentage of equity. While these type of startup and investor deals make headlines, really they are no different than any other transaction – a seller wants the highest value for their offering, while a buyer wants the best product or service for the lowest price.
When investors invest in a company however, they are buying into the future value of a company; and using previous and current value to assess how high that future value may be. For an established company, investors can look at financials over several years and use historical data to predict the future performance of a company. Early-stage startups don’t have historical financial data though, and value must be assessed by examining other important factors. Investors have to be especially realistic about the value and potential of a startup; on average, 75% of venture-backed startups don’t make it far enough to return cash back to the investor.
There are many different elements that can be considered for a pre-revenue startup as a proof of potential; but really, which factors are most relevant and which are weighed most heavily is highly dependent upon the type of business itself. A social media app, for example, may be able to garner a high startup valuation solely off of a large user base – while a B2B SaaS solution may need to prove their potential by showcasing long durations of user sessions and a high percentage of conversions to paid subscription packages.
Through our discussions with several investors, CPAs and other financial parties, we’ve narrowed down the three most important factors for a high pre-revenue startup valuation – a strong founding team, proven traction, and a viable future financial projection. In the following sections, we will examine each of these factors, explain how they relate to value, and teach you how to strengthen these factors for a better startup valuation.
The Value of a Founding Team
For a pre-revenue startup, one of the greatest predictors of success is the strength and experience of the founding team. A team of founders that have a history of bringing other startups to success, for instance, would be more highly valued than a team of first-time entrepreneurs with little experience. Furthermore, a team of four people with diverse and focused skills would typically provide more value to a startup than a single founder team.
Mike Raab, investor at Sinai Ventures in San Francisco explained exactly why a strong founding team is so important when he considers investing in a startup. Mr. Raab explained, “At an early-stage company, the most important factor that investors consider is the startup team. Does the team have demonstrated success and experiences that make them uniquely qualified to build a venture-scale business in this sector? Ideas are frankly very common (there are often many different companies building similar products to solve the same problem), and investors look for the team that has the background and knowledge to perform and outlast the rest.”
How strong is your founding team? Here are a few attributes of a valuable team:
- Proven Experience: Investors want to know that a startup team has what it takes to succeed. Startup founders that were previously involved in other successful startups are immediately valued higher than founders with no experience. As an extreme example; if Mark Zuckerberg walked into an investor’s office, his reputation would most likely precede him. His past success with bringing startup ventures to the top would be extremely valuable to any new business he participated in. However, it’s not just those with a successful entrepreneurial background that are valuable to a business. A developer that had a significant position at a well-known software company may have an advantage when developing his own software. A successful financial manager may have an advantage when pitching a financial solution since he has unique experience within the industry. How one’s experience can benefit a specific startup is subjective – but experience plays a major role in the way an investor perceives the associated risk of a startup.
- Skills Combination: A startup team should consist of several individuals, who each have a different but complementary skill set that can help progress the startup. A programmer with no marketing background may benefit from having another programmer as their partner; but the team could be much more effective if he/she partnered with an experienced marketing expert instead. Identify what skills are necessary to scale your startup and seek to fill in those gaps to increase your team’s overall value.
- Commitment & Dedication: Having a great founding team means very little if none of the team members are actually available to execute the required work. For example, a developer that is involved in multiple projects may have very little time to allocate to building the software – and while they may be a valuable member, their involvement is devalued by their time limitations. Build your team with highly-motivated individuals who are committed to bringing the startup to success.
- Advisory Board: It’s not just your founding team that is important, but value can also be found in people who advise the board when making important decisions. Experienced advisors can help startups avoid obstacles, help them make more informed decisions, and can even introduce them to potential investors or clients within their network. Look for mentors you can lean on – successful entrepreneurs, industry leaders, and individuals who have the knowledge to help you in your mission.
How much is an awesome team worth, exactly? Well, it’s not quite that clear cut. According to Ken Stalcup, CPA at Houlihan Valuation Advisors; it’s not the team itself that adds the value, but the revenue that those members can generate as a result of their experience. While telling us the process of calculating startup valuation, Ken told us, “We definitely consider the potential for the startup team, their experience, their expertise and so on. [However,] we wouldn’t typically associate a particular value for the startup team; rather, the startup team would be a factor considered when determining the potential growth and quality of future revenues. The better the team – the better the prospect for future revenues.”
Traction is Proof of Concept
When it comes to startup valuation, traction tells the true story of the business – and it doesn’t always come down to revenue. Mike Raab explained, “If a company can organically (without paid marketing) acquire a significant number of users, or demonstrate very low CAC (Customer Acquisition Cost) compared to the potential LTV (Lifetime Value) of the customer, the unit economics are more favorable for venture investors.” In other words, what really brings value to a startup is proof and evidence that an idea is viable and scalable to a large market.
Which metrics you use to prove effective traction will be specific to your startup; however some of the most important app metrics for startup traction include number of users, a proven app marketing strategy and a strong growth rate.
Number of Users
A solution that has acquired a large number of users (compared to the size of it’s addressable market) will have a higher valuation. By securing a large quantity of users, startups can prove that they are able to attract consumers, that users are satisfied with their product, and that there is an existing network that can be monetized.
What does a large number of users look like in solid numbers? Obviously, it’s not that simple. The goal is to penetrate the addressable market, but not all markets are equal in size – and therefore, what seems like “many users” for one app solution, may seem like very few users for another. For example – A solution that serves a large portion of the market, like a social media app, may need 100,000 users to make an impression; while a B2B solution that monetizes consumers with a monthly subscription may be able to show exceptional traction with only 500 paying users.
Having a large user base is a major accomplishment, but what really matters is how those users behave once they have downloaded your application. A million users sounds amazing if that is the only information given – but is it still amazing if 998,000 of those users never returned to the app after using it once? In this situation, having a large user base actually hurts value and shows that a major flaw exists. When considering the number of users during your startup valuation, consider the whole story by analyzing a variety of user metrics such as user retention, daily and monthly active users, session length and more.
In terms of the value of a user base, Ken Stalcup commented, “The value of current users is similar to the overall value of the company. That is, we typically want to see a projection of the revenues associated with the existing users. From there, annual cash flows from current users can be calculated and a present value can be associated with that income stream. Obviously, as [the number of] users grow, there will be more value. If users are anticipated to decline, value will decline.”
Effectiveness of Marketing
As Mike Rabb mentioned, a startup that has proven its ability to acquire high value customers at a low cost has a major advantage when seeking investment. Even if current users have not yet been monetized, showing that a strong marketing strategy has been identified and optimized has the potential to increase startup valuation significantly. Taking a small marketing budget and generating a substantial number of users (in comparison to acquisition costs) proves that with a larger budget, the startup would be able to scale its user base exponentially with little risk.
What makes a large existing user base even more attractive? Knowing that it’s going to keep growing and growing in the near and distant future. A history of incremental scale and growth, even if small, can add considerable value to your startup. If you can grow consistently with a small budget, the potential is great that you will be able to scale larger and at an accelerated pace with the investment of an angel or VC.
Here’s the key to gaining traction. These three concepts are interconnected – a super effective marketing strategy leads to strong growth; and when your growth is strong, your user numbers inevitably increase. Figure out the first things first – build a great solution that is in demand by your market and learn how to get it in front of your consumers at a low cost.
How Valuable Can Your Startup Become?
While there may not be a hard monetary value on each of the factors we explained, all of them fit into the overall value of a startup. Hard metrics like number of users, customer acquisition costs and per customer monthly spend can be directly accounted for in a financial projection – but intangible assets like founders’ experience provide a measure of confidence that the projections can actually be reached, and this is equally as important.
Ken Stalcup gave excellent advice into how his firm typically calculates a startup valuation: “To put a value on a tech startup, we would typically want to see a five-year projection of the company’s future revenues and expenses. Using those projections, we would develop an estimate of the annual cash flows, add all of the estimated annual cash flows together and calculate the present value of that total number. Pre-revenue startup valuation is accomplished by calculating the present value of the estimated future income stream of the company.”
The Perfect Mix For The Best Startup Valuation
What does a valuable pre-revenue startup look like to an angel investor or a venture capital firm? Mr. Raab explained why his firm, Sinai Ventures, recently decided to invest into a startup called Kapwing: “In July, Sinai Ventures invested in Kapwing, a free software tool for intuitively creating and editing video content and memes. While the company had some revenue, it wasn’t of material scale. However, the co-founders had a clear product vision and had built an impressive user base completely organically in just a few short months. Their backgrounds, traction, and expertise & excitement about what they were building made it an easy decision for us to invest.”
When a startup gets funded at a high startup valuation, it’s typically because they have the perfect mix of positive elements that prove the likelihood that the startup will succeed and generate a substantial return. When you can easily prove that your startup possesses all the pieces needed to achieve grand success, the value of your company will increase and you will be better able to calculate a fair financial ask and equity offering.
Mr. Raab gives the following advice for startups that are seeking investment at the highest valuation: “Get your product in front of customers, get their feedback, and iterate until you have customers who love your product. Product-market fit doesn’t necessarily mean revenue – it means demonstrating that there is a core user for your software who loves what you’ve built and is willing to pay for it (in one way or another). If you have customers willing to provide reference calls on your behalf to tell investors why they love your product, why they’re willing to pay for it, and why it’s better than the competition – investors will take notice.”
Need help creating financial projections to better assess your startup valuation? Our experts can help. At ThinkLions, our business plan writers and consultants have worked with hundreds of startups around the world – creating app business plans and pitch decks that have helped raise millions of dollars in investment. Contact us today to discuss how we can help you bring your app startup to life!