How to Value a Pre-Revenue Company

In the last two decades, several start-ups (like SpaceX and Snapchat) have reached unicorn status (a valuation of over $1 billion) while generating little to no revenue. This phenomenon raises questions about valuation methodologies.  

This article discusses the intricacies of valuing pre-revenue companies, exploring the challenges, key factors, and suitable valuation methodologies.  

Understanding Pre-Revenue Companies  

Pre-revenue companies are those that have yet to generate income from product or service sales. They are generally characterized by:

• Concept Validation: They are still proving their concept, identifying the product-market fit, testing market viability, and developing a prototype.  
• High Cash Burn Rate: Significant operating losses due to heavy investment in development and growth.  
• Aggressive Growth Strategies: Prioritize rapid expansion and user acquisition.  
• Heavy Reliance on External Funding: Often relies on external fundraising to fuel future growth,  
• Learning-Oriented Approach: Lacks business management experience, and the leadership team often learns on the go.  
• High Tolerance for Experimentation: Tends to be more open and flexible when it comes to experimentation and problem-solving. 

Traditional Approaches to Valuation 

The three widely accepted approaches to business valuation are the asset, income, and market approaches. However, for the reasons discussed below, these traditional approaches are not well suited for valuing a pre-revenue company. 

Asset Valuation  

The asset approach considers the value of a business’s assets, net of liabilities. The approach is generally considered to yield the minimum benchmark of value for an operating enterprise, primarily because it does not specifically consider the value of intangible assets or goodwill.  
Given that the asset approach estimates value on an “as-is” basis, does not factor in the business's future growth potential, and does not consider the value of intangible assets or goodwill, it does not yield an appropriate estimate of value for a pre-revenue company. 

Income Valuation

The income approach is based on the principle that the value of a business is equal to the present worth of the future benefits. The approach estimates value through a function of the income generated by the company and a rate that reflects the risk inherent in expected future earnings (i.e., the cost of capital). The company’s income is based on historical and/or expected financial information (i.e., forecasts), and the cost of capital is estimated using market-based information and information about the subject company. 

Given that the pre-revenue companies do not have a positive cash flow stream due to a high cash burn rate resulting from no revenue and heavy operating expenses, the income approach does not yield an appropriate estimate of value for a pre-revenue company. 

Market Valuation  

The market approach estimates the value by comparing a company to its peers in public companies or precedent transactions. The approach is based on the principle that a business will sell for roughly a similar multiple (of earnings/revenue) to other companies in a similar industry and size.  

Given that a pre-revenue company would not have a steady and sustainable financial metric (earnings/revenue) and that there may not be many comparable companies operating at similar sizes in a similar space, the market approach does not yield an appropriate estimate of value for a pre-revenue company. 

Factors Affecting Valuation of Pre-Revenue Companies 

• Market size and opportunity 
• Competitive landscape 
• Industry 
• Regulations 
• Technology 
• Founder and team 
• Stage of the company 
• MVP (Minimum Viable Product)/prototype/moat 

Valuation Methodologies for Pre-Money Companies 

Venture Capital Method 

This method combines aspects of both the discounted cash flow approach and the multiples-based approach. 

The fair value in this method is estimated using a two-step process: 

1. Calculate the company's terminal value in the harvest year. The terminal value is the expected value of the company on a specified date in the future. The harvest year is the year in which the investor would target exiting the company. 
2. Track the terminal value backward with the expected return on investment (ROI) and the investment amount to calculate the pre-money valuation. 

To understand this method better, let us take an example of Company X with the following assumptions: 

• Forecast Period: 5 Years 
• Forecasted Revenue at End of Forecast Period: $20.0 million 
• Forecasted Net Profit Margin: 10.0%  
• Long Run Sustainable Industry Price-to-Earnings Multiple: 12.0x 
• Investors’ ROI: 10.0x 
• Planned Investment: $1.0 million 

Based on the above information, the value for Company X will be estimated as follows: 

• Terminal Value (Projected Revenue * Profit Margin * Industry Price-To-Earnings Multiple)  
  
  • $20.0 million * 10.0% * 12.0x = $24.0 million 
• Pre-Money Value ((Terminal value / ROI) – Investment amount)  
  
  • ($24.0 million / 10.0x) - $1.0 million = $1.4 million 

As presented above, the value of Company X could be $24.0 million in five years. 

Pros 

• Encompasses risk and anticipated return. 
• Highlights the importance of exit strategy. 

Cons 

• High reliance on exit value. 
• The rate of return is based on assumptions that introduce subjectivity. 
• May not be appropriate for industries with low exit multiples or unclear exit strategies. 

Berkus Method 

This method values the company based on its value drivers, which include, inter alia, the business idea/concept, prototype/technology, the quality of management, the strategic relationships, and the product rollout/sales plan. The drawback of this method is that it does not consider market factors. 

In our example of Company X, the factors considered and the estimated value allocated to each factor are mentioned in the following table: 

Pros 

• Simplifies the process by focusing on key value drivers. 
• Suitable for pre-revenue companies as it does not rely on financial data. 

Cons 

• Highly subjective because of the allocation of values to key value drivers.  
• Not suitable for later-stage companies. 
• May not be applied to companies with unique business models or emerging industries. 

Chicago Method 

This method, also known as the “First Chicago” method, is based on cash flow predictions and scenario analysis. Financial projections are made for different scenarios (for example, base case, best case, and worst case), and weights are allocated to each of these scenarios. It is effectively a discounted cash flow analysis. The company's equity value is the weighted average value of the scenarios. 

Let’s continue with our example of Company X. The scenarios considered, the equity value calculated for each scenario, and the weights allocated to each scenario are presented in the table below: 

Pros 

• Combines multiple scenarios to provide a holistic view of the company's probable outcomes in various scenarios. 
• Considers probabilities of various exit scenarios and financial performance of the company. 

Cons 

• The basis for probabilities assigned to various scenarios can be subjective. 
• Significant efforts may be required to develop and analyze multiple scenarios. 

Scorecard Method 

In this method, a company seeking to determine its value is assessed to identify certain qualitative factors that directly impact its valuation.  These parameters are compared to a benchmark company in a similar industry that has already received investment. Some of the parameters and the probable range of weights that may be assigned include: 

Ranking these factors and determining appropriate weights may be a very subjective process. 

The next step in this process is to assign a factor to each of the parameters based on the quality of these parameters in your company compared to the benchmark company to determine a factor strength. The factor may be more than 100%, less than 100%, or equal to 100%. The last step is multiplying the sum of the factor strength by the equity value of the benchmark company. 

Let’s take an example of valuing Company X. In this case, the benchmark company is Company A, which has an equity value of $2.0 million. 

 Pros 

• Easy to understand and apply. 
• Considers a range of qualitative factors. 
• Adjustments based on its relative strengths and weaknesses compared to the benchmark company. 

Cons 

• Reliance on availability and accuracy of data for the benchmark company. 
• Subjective analysis as it involves assigning weights to various factors. 
• May not apply to companies pertaining to niche/emerging markets with few comparable companies. 

Risk Factor Summation Method 

This approach combines the aspects of the Scorecard and Berkus methods with a prime focus on the company's risks. This method considers the following risks: 

• Management 
• Stage of the business 
• Legislation/political risk 
• Manufacturing risk 
• Sales and marketing risk 
• Funding/capital raising risk 
• Competition risk 
• Technology risk 
• Litigation risk 
• International risk 
• Reputation risk
• Potential lucrative exit 

Each risk area is given a score and a monetary value based on the following criteria: 

In our example of Company X, the equity value will be calculated as follows: 

Pros 

• Easy to understand and apply. 
• It considers areas that are often overlooked by other methods. 

Cons 

• Subjective analysis as it involves assigning monetary values to various risk factors. 
• Excessive focus on risk factors may lead to overlooking the company’s future potential. 

Conclusion 

Valuing pre-revenue companies is a complex task that requires careful consideration of market dynamics, competitive landscape, team expertise, and the strength of the company’s technology and business model.  

By understanding the limitations of traditional valuation methods and employing suitable methodologies like those discussed above, investors and entrepreneurs can make more informed decisions in the pre-revenue stage.  

Use the form below to connect with our team if you have questions about any of these approaches or need assistance going through a valuation analysis.