Valuation – Magic, Myths, and Methods

Apr 14, 2021

by Jeff Amerine

Raising money sucks. It sucks for founders. It sucks for fund managers. It pretty much sucks for everyone. Part of what adds to the suckiness for founders is the dark art of valuing your company. The conventional financial valuation methods used by CPAs and Certified Valuation Professionals are beyond useless for pre-revenue or early-revenue ventures. Typically, there are no tangible assets, no operating history, and for sure no net income.  

So, what to do?  

Some would say just do a Net Present Value (NPV) of the Discounted Cash Flows (DCF) for your forecast… Did I mention your forecast is a complete work of fiction based on fictional assumptions and no operating history? That said, pitch that method in the compost heap. Forecasts like this and the valuations that result elicit an ejection seat activation from investors nearly every time.  

Others might suggest – well most businesses are valued at 3-5 times earnings before interest, taxes, depreciation and amortization (EBITDA). Fantastic! Except you have none of that. You are pre-revenue or early revenue and are burning cash trying to acquire customers and rollout products or services.  Here again, pitch this one into the rule of thumb trash heap.

You turn to Crunchbase and Pitchbook and you see all the incredible $10M+ valuations for pre-revenue tech ventures in Silicon Valley and you say to yourself, “Self, our deal is definitely as good as any of those.” Frankly, your deal might be better than all of those but you are likely not sitting in Silicon Valley and not paying an army of average software developers $300K/year so they can work remote on your venture from the trailer they can barely afford to share with their three roommates near the Federal Prison in Lompoc or if they are really lucky near the garlic plant in Gilroy. Definitely don’t get caught up in basing your valuation on anything happening in Silicon Valley unless you are there. 

Okay. This is not hopeless. Here are a few strategies that can work.

1.      Look for geographic comps (comparable ventures) that have raised money recently near you.  This gives an indication of what relevant investors would assess to be reasonable.  Geographic comps take into consideration what the market of investors value in your area or areas similar to yours.  You can find some of this data through Crunchbase, PitchBook, or through networking with other entrepreneurs who have knocked raises out.

2.     Consider the Berkus Method.  Berkus has an estimation process on valuation that includes these factors:

If Exists:                                                                                    Add to Company Value up to:

1. Sound Idea (basic value, product risk)                                                     $1/2 million

2. Prototype (reducing technology risk)                                                      $1/2 million

3. Quality Management Team (reducing execution risk)                             $1/2 million

4. Strategic relationships (reducing market risk and competitive risk)         $1/2 million

5. Product Rollout or Sales (reducing financial or production risk)                $1/2 million


This implies that if you maxed each category out your pre-money valuation could be as high as $2.5M.  Here’s the link to his site

3.     Skip it. It is probably too early to do a priced round. Instead consider using either a convertible note or a SAFE. These methods put off locking down a firm valuation for a priced round until you have proven a few more things like actually getting customers to buy your solution. Typically, these structures will give you up to two years before you lock down a valuation for a priced round.  That said, many times a convertible note will offer a discount rate to the early investors when a qualifying equity round is raised or will place a cap on the valuation or both.  The cap can be tricky.  Set it too high and you are back in the same barrel described earlier.  You can learn a great deal more about the nuances of these structures with the Angel Capital Association (ACA) or in Brad Feld’s book, Venture Deals

Markets are brutally efficient.  You’ll know you may have an unrealistic valuation if you can’t attract any investor interest (assuming you are otherwise building something of value and aren’t crazy).  You may also be building something that the investors in your geography don’t value.  Most investors, invest in solid management teams with realistic valuations in sectors they understand.

If you want to make the process suck a little less (it will still suck – mind you) schedule a call with your friendly neighborhood Startup Junkies. We’ve seen all sides of this process and are here to help!