How Do Investors Value Pre-

Revenue Companies?
Quora , Contributor
Forbes | 2014-01-24

Answer by Leo Polovets, Partner at Susa Ventures, Early LinkedIn/Fac-

tual engineer, Ex-Googler, http://codingvc.com, on Quora,

Deciding how to value pre-revenue companies is hard. There are

many signals to process, and even after you've taken all of them into
account, the final estimate is as much art as science. Deciding how
much a startup should be worth is like deciding how much a one-of-a-
kind painting should be worth: there are guidelines to move you in
the right direction, but in the end you're basically making an edu-
cated guess. What's worse, you don't truly know if your guess was
good until long after you've made the investment. Despite that bleak
disclaimer, there are heuristics for calculating the value of a startup
-- even one that has yet to make a dollar in revenue.

First, let's start with a few thought experiments. For each thought
experiment, let's pretend you've been approached by a startup called
ShopBetter, a company focused on improving shopping for buyers and
for retailers, and you have the opportunity to acquire a 10% stake in
the company. Your goal is to determine how much that 10% should be
worth.

Thought Experiment #1: Founding Team

ShopBetter was founded last week and the founders know they want
to improve shopping, but they haven't decided exactly how they'll do
that. However, they are committing to work on something together
for at least the next 5-10 years.
 If the founders are your neighbors who don't know anything about
technology or shopping, then 10% might be worth a few hundred or a
few thousand dollars (if you happen to be a generous gambler).
If the founders are great engineers and salespeople that you've
worked with, then 10% might be worth tens or thousands of dollars.
Maybe even a million dollars.
If the founders are , , and , then 10% might be worth tens or even
hundreds of millions of dollars.

Thought experiment #2: Traction and Expected Near-Term Reve-

nues

ShopBetter recently released a service that lets retailers learn more

about their customers. ShopBetter's businss proposition is that richer
demographic info will help those retailers promote and target their
products more effectively.

If ShopBetter has 3 pilot customers who are nowhere near

becoming paying customers, then 10% might be worth a few
hundred thousands dollars (mainly because a finished
product with potential is still worth something).
If there are 50 pilot customers, the plan is to charge each of
them $1000 per month, and you believe (through surveying
a few pilot customers) that about half of 50 will become
paying users, then you might value 10% of ShopBetter at
something like $500k or $1m.
If the company has 1 pilot customer and plans to charge
$50k/month, and you think the customer has a 50% chance
of converting to paying, you might value a 10% stake at
$300k - $500k. Even though a 50% chance of one customer
at $50k/month has the same expected value as 25 customers
at $1k/month, the proposition is more risky because it
depends on a single client. As a result, the valuation take a
hit.

Thought experiment #3: Growth and Engagement

The team at ShopBetter has been busy and launched a mobile app 3
months ago. Based on your research of similar shopping apps, you
think a typical user's lifetime value (LTV) will be about $2.

If the app has 100k users and the user base is growing 15%
per month, then 10% of ShopBetter might be worth $500k.
If the app has 100k users and the user base is growing 30%
per month, then 10% of ShopBetter might be worth $1.25m.
If the app has 100k users and the user base is shrinking
10% per month, then 10% of ShopBetter might be worth
$200k. There's still potential value in the company if they
can figure out how to improve their app and get the user
base to grow, but a shrinking user base is scary signal.

Additionally, user engagement is important. 100k users who log in

monthly are not as valuable as 50k users who each use the app for 20
minutes per day.

Thought experiment #4: Market Size

You've analyzed the market for ShopBetter's consumer app -- the one
where each new user is worth $2 in revenue -- and have come up with
a realistic estimate of the max number of consumers ShopBetter can
expect to acquire.

If there are 500k potential users, 10% of the company might

be worth $50k.
If there are 10m potential users, 10% of the company might
be worth $1m.
If there are 500m potential users and you think ShopBetter
has a good chance of acquiring most of those users, then the
value of a 10% stake is only limited by your optimism and
your bank balance.

Thought experiment #5: Competition

 You've take a good look at ShopBetter's founding team, its 100k app
downloads so far, and its market potential, and now you turn your
focus to the competitive landscape.

If ShopBetter has no competitors, you might value a 10%

stake at $500k.
If it has two competitors which each have 25k users, you
might value a 10% stake at $400k.
If ShopBetter has several competitors with millions of users
each, and Amazon just announced a similar product, you
might value the 10% stake at $200k.

These thought experiments are meant to show how different attrib-

utes contribute to the value of a company. (The numbers are meant to
be illustrative, not exact.)

In addition to these factors, there are other things at play when deter-
mining valuations:

Market forces. It doesn't matter if you think a company is worth $5m

if other investors all think it's worth $7m. If the market says it's $7m,
then it's $7m.
Quality of other investors. If a startup has very notable investors, it
might be able to command a small premium. Having a founder's
parents invest $250k is a much weaker signal than having Sequoia or
Greylock invest $250k. Additionally, institutional investors have
deeper pockets, and if a startup has funding from such investors then
there's a greater chance it will be able to to raise more money if it
needs to. (According to , the rate of follow-on funding jumps from
35% to 47% for companies that raise seed money from VCs.)
Comparables. If most comparable startups are valued within a
certain price range, then that price range provides an anchoring
point. For example, if a typical B2B startup with a recently launched
pilot product and 1-5 non-paying pilot customers is usually worth
$4m-$6m, then any new startup in that category will be valued
similarly unless there are strong signals that drive the valuation up or
down.
Market forces and comparables are especially potent. Oftentimes, a
founder will look at what valuations their friends are raising at then
pick a number out of thin air. Then they offer that price to several
investors, and if investors don't push back, that becomes the final
price.

The way that I approach valuations -- and I'm speaking for myself and
not for other partners in my fund -- is to first look at comparable
companies to get a baseline value for a company. I then try to make
reasonable adjustments for exceptionally good founding teams, mar-
kets, products, or growth/usage metrics. In the end, I come up with
an estimate that I can compare to the estimates of my partners. If our
estimates are in a narrow range, then we're satisfied; if they're
wildly different, then we scrutinize our individual assumptions until
we're on the same page.

On final note, valuations do matter, but exact valuations do not. The

average return of an angel investment is , and it's okay if your valua-
tion estimates are off by 5-10% once in a while. (An average, well-
diversified portfolio should return about 2.6x, and 90% of that is still
a healthy return). For a professional fund, the goal is to have better
than average returns (e.g. 4x or 8x), and in that case, the quality of
companies that you invest in becomes more important than your abil-
ity to calculate their valuations to the nearest dollar.