To better grasp the cut-throat reality of venture capital, we can look at the data from 1986 to 2018 that was generously shared by the long-playing fund of funds VenCap. As Michael Sidgemore aptly pointed out, "If there’s a chart that captures the power of the power law, it’s this one." A mere 1.1% — equivalent to 121 companies — out of the 11,350 companies involved in the underlying fund yielded fund-return results.

Image: The newsletter AGM Alts Weekly from 8.27.23

Put simply, even seasoned institutional investors find it challenging to pinpoint promising startups, a task that becomes even more daunting for angels. The determinative question in this selection process is: How much is a startup worth (or can be worth), and, therefore, how much investment should the current round receive?

In most cases, angel investors will just be offered to follow the terms set by the founders and approved by the lead investor, leaving little to no room for negotiation on valuation. But you should still understand where the numbers come from, so we've put together some basic rules for pre-seed/seed assessment.

Classic techniques for a pre-money valuation

Navigating the maze of pre-money valuation involves a critical choice: Do you base it on analogs or embrace the startup's uniqueness? Do you rely on ongoing sales or project future cash flows? These questions linger, and each investor charts their own course.

Here are a few tried-and-true options:

• The Venture Capital Method

What's the point?

This method hinges on projecting the startup's value at the time the investor exits the company. Two key indicators play a vital role: pre-investment and post-investment assessments (factoring in the duration until the investor exits).

What are the steps?

1. Set the expected exit value considering the startup's growth potential, market conditions, and country-specific risks.
2. Determine the target rate of return.
   
3. Calculate the pre-money valuation using this formula: future exit value / (1 + required rate of return)^(exit timeframe in years).
   
4. Adjust the value to account for dilution.
   

Let's break it down with a little example: 

If a startup is supposed to be worth $150 million in three years, aiming for an ROI of 30%, crunch the numbers like this: $150 million / (1 + 0.30)^3. So, the estimated pre-money valuation using the Venture Capital Method hovers around $68.3 million. 

• The Berkus Method

What's the point?

This method adopts a qualitative approach by breaking down a pre-seed stage startup's value into five crucial components, each valued at up to $500,000. These components are idea, team, prototype, partnerships, and rollout.

It's a handy tool, especially for vertical startups where assessing the market and prospects is more straightforward. Keep in mind, though, that this method requires careful consideration due to its subjective nature. 

What are the steps?

1. Check if the startup's business idea holds promise. Look for indicators like patents, scalability, social significance, and how well the idea has been validated and planned.
2. Dive into the management team. Consider the founders' track record with successful exits, the achievements of key managers in their previous roles, and whether they've worked together before.
   
3. Examine the prototype and technology. Assess how well it aligns with the idea and demonstrates the concept’s viability.
   
4. Investigate if the startup has valuable partners. Look for contacts with established players who bring experience and connections to the table.
   
5. Find out if there are any sales or notable successes during the product rollout.
   
6. Rate each of these factors from zero to $500,000.
   
7. Add up these scores and get the final valuation of the startup in the range of $0 to $2.5M. 
   

That's how the Berkus Method approaches risk factors. (Image: Eqvista)

• The Scorecard Method (also known as Bill Payne Valuation Method)

What's the point?

This method is a concoction of quantitative and qualitative characteristics. It's about putting the startup side by side with very similar ones — same location, same phase, same playing field. The criteria used to compare can vary.

What are the steps?

1. Locate the "twins". To identify startups with known valuations that closely resemble the target one, leverage networking and databases like Crunchbase and AngelList (by the way, we recently covered these and other valuable tools for investors).
2. Сalculate benchmark. Once you have a selection of comparable startups, count their average valuation.
3. Determine key factors for comparison, such as market size, product scalability, team experience, revenue growth potential, and other relevant parameters.
4.  Assign a "weight" to each factor based on its perceived importance and relevance. This weighting is usually done as a percentage (e.g., 5% to 30%) to ensure a total of 100%.
   
5. Compare every factor between the selected startup and the analog. Does the analog have a stronger team? The comparison should be less than 100%. Does the analog have more competitors? The comparison should be more than 100%.
   
6. Calculate the strength of each factor. For it, multiply the weight by the comparison result.
7. Sum up all the factors' strengths to obtain the chosen startup’s valuation ratio to the benchmark.
8. Multiply this ratio by the benchmark. For example, if the average valuation is $1.7 million and the ratio is 1.13 (as in the table below), the valuation you are looking for would be a little more than $1.9 million. 
   

To make it clearer, here are some conditional calculations. (Image: StartUs)

Some tricks for the road

Of course, we've only scratched the surface. Various methods, such as Discounted Cash Flow Analysis (DCF) and Risk Factor Summation (RFS), also fit most situations when it comes to early valuations. 

For more full-grown companies with in-depth financial data, the 409A valuation will define fair market value. Beware, though — this approach is way more challenging, as it demands a nuanced understanding of equity, debt, and other complex factors.

Here are some guiding principles that stand tall, no matter which valuation route you take:

• When estimating future exit value, always factor in potential dilutions in subsequent funding rounds. Typically, as a pre-seed investor, you will be diluted by 58% by the time your stellar startup closes its Series D, Carta says.

• Recognize the significance of intangible assets. Ensure that no patents, trademarks, or unique technologies are overlooked during the assessment.

• When drawing insights from similar startups, opt for the freshest valuations. Consider the impact of crises and upturns, witnessing how these market shifts influence their trajectory.

• While online calculators can assist estimations, it's prudent not to rely solely on their results. Many tend to twist valuations to attract a broader audience. Additionally, such apps primarily focus on Silicon Valley data without considering other regions' specifics and differences.

And above all, meticulously scrutinize all the information provided by the founders. Avoid situations where the startup appears impressive on the pitch deck but falters in practice, akin to the rice vending machine meme. Make sure the innovation isn't just adding complexity like those viral gym-goers doing things the hard way.

Yes, that's a red flag too. (Image: Memelogy by Dagobert Renouf)

Cover image: Unsplash