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How do VCs value a startup that has yet to receive a dime in revenue?

Answers

Mark Stokes
Title: CFO
Company: Private
(CFO, Private) |

By guessing! Seriously. It's all a big gamble for them. Yes, they will try to fit you in to some "box" of familiar companies in similar spaces or in similar business models, but at the end of the day they are just taking a stab. What guides that stab frequently is their need to own a certain % of your company to even bother making an investment in you. For instance, many VCs want to own 20% of your Series A, assuming that in future rounds they will be diluted to 7-10% ownership. Thus, if their ownership percentage equals their investment divided by the valuation of your company plus their investment, then knowing their target ownership and either of the other numbers (your company value or their investment interest in $'s) allows you to solve for the third element (whichever element you don't know).

There is no DCF or comp valuation in pre-revenue companies, only a gut feel from the VCs and a negotiation by the company.

Randall Lucas
Title: CEO
Company: SimpleVerity
(CEO, SimpleVerity) |

Mark is right but it's not the whole picture. The other crucial element is competition. If there are multiple term sheets (for a "hot" deal) then an auction inevitably ensues; it may be a relatively open auction if the valuation is leaked to others, or it may be the equivalent of a sealed-bid auction where VCs guess what other VCs have bid, and try to one-up them.

That said, most of the time pre-revenue valuations are in a reasonably narrow range of what is "market" in a given time and geography. (Which is also implicitly an auction, for that matter.)

Scott Page
Title: Founder
Company: The Fractional Controller, Inc.
(Founder, The Fractional Controller, Inc.) |

From my experience, VC's also factor in the quality of the venture's management. While the elements of technology, market and competitive landscape are significant, a lack of confidence in management's ability to implement the business plan will factor into their commitment and assessment of their return on exit. I've seen this element's significance manifest itself in a VC's decision whether to invest at all.

Ted Monohon
Title: VP -Finance / Controller
Company: Fantex
(VP -Finance / Controller, Fantex) |

For successful VCs, it is a well educated guess, more rational than just a gamble, and not a "gut feel".

For companies with no revenue, the investors look at a myriad of things (not in order and not limited to):

1. Management team - how experienced is the team in that particular industry?
What has been their track record at managing companies? How well equipped are they to execute on the presented business plan?

2. Competitive landscape - Who are the competitors? How many? What are the barriers to entry (patented / legal barriers? large capital requirement or unique, specialized knowledge)

3. What is the key differentiator with the business? Technology? Business Process? What is going to make this business successful?

4. What level of investment is going to be needed to get to critical mass (revenue or break even)? How many additional rounds of investing might be needed (assessing dilution)?

5. What is the size of the market the business is trying to capture? The smaller the potential market, the less interesting it is to the investor.

Again, I would not agree with the generalizations made earlier that VC investing in pre-revenue companies is made as a "gamble" or on a "gut-feel". Initial VC investments in Google, Facebook and other well known companies were all done "pre-revenue".

Topic Expert
Darren Cordier
Title: President
Company: FV Specialists, Inc.
(President, FV Specialists, Inc.) |

Pre-revenue entities are often valued based on the investment to date unless they have reached a significant milestone in development. Part of that investment is the sweat equity. This is a very subjective component of the value proposition.

Negotiation strength of the VC is often the most important function in how much funding will be contributed and how much ownership they want for it. The factors that Ted noted are all part of that negotiation. Remember, a business that is this early stage is most often valued using qualitative factors, not quantitative. Have a compelling value proposition that is not easily replicated and get VCs competing for the investment to maximize your value.

Gary Honig
Title: President
Company: Creative Capital Associates Factoring Co..
LinkedIn Profile
(President, Creative Capital Associates Factoring Company) |

As a point of clarification, venture capital (VC) is usually a managed fund, meaning the VC firm has gone out and raised capital to be used to invest in investment grade opportunities. So these managers are looking to maximize the ROI on all of their decisions. This is investing by committee where layers of people are in on a final decision to invest.

In today's world you will not find a managed fund be the first money in the door (except in extreme situations dealing with a brand name entrepreneur.) First the company should raise a round of seed money to turn on the lights, then try to hook up with a few Angels to get the model started and also to keep raising more capital.

All of the aspects pertaining to whether an investment is a good idea mentioned above apply. A pre-revenue company better have a good story as to where the revenue is coming from and when it will arrive.

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