For most startups, early financing comes from two places – friends and family or angel investors. Now, the investors in the friends and family round are not necessarily real friends or family members, though they can be. Generally, they are investors willing to invest their personal finances because they like the founders or believe in the startup's work. Alternatively, angel investors are wealthy individuals who are entrepreneurs themselves or small entities formed to invest in other businesses. Their investments are usually sought after the friends and family round.
Valuation Before Revenue Starts
In order to garner financing, startups need to understand the value of their company. Valuation provides invaluable information for potential investors who hope to receive significant returns on their investment. Mature startups are valued using the EBITDA formula:
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
But pre-revenue startups do not have these figures to rely upon. Instead, valuation is estimated based on traction, the founding team's experience and skills, and how high the startup expects the profit margins to be.
Different Methods for Valuation
One of the more popular startup valuation methods asks the evaluator to compare the startup to other already funded startups. After determining the average valuation for similar pre-revenue startups, you compare:
- The strength of the management teams,
- The size of the opportunity,
- The product or technology offered,
- How competitive the market is,
- The growth and engagement of the user base, and
- The need for additional investment.
The Venture Capital method is a two-step process that requires the evaluator to:
- Calculate the terminal value of the business in the harvest year; and
- Calculate the pre-money value by tracking backward with the expected ROI and investment amount.
To calculate the terminal value, you must multiply the projected revenue with the projected profit margin and multiply that by the industry stock price-to-earnings ratio.
Terminal Value = projected revenue x projected profit margin x P/E
To calculate the pre-money valuation, you divide the terminal value by the ROI, mins the investment amount.
Pre-Money Valuation = (Terminal Value / ROI) – Investment Amount
How an Attorney Can Help
Properly valuing your startup is essential for attracting investors. During the friends and family round, you may feel like this step is unnecessary, but the truth is, having a pre-revenue value of your company will only help to ease their minds. Investors who innately trust you and your company will contribute as much of their personal finances as they can. By understanding your pre-revenue value, they will be able to mitigate their expectations on their investment return.
An experienced startup attorney can help you determine the value of your company even in the early stages. Attorney Mohsen Parsa is a highly skilled business, corporate and startup attorney in the Irvine, California area with years of experience working with startups.