As many of you know, I’m in the process of trying to launch a new product and a new company. One of the challenges with trying to raise investor capital is figuring out how much the company is worth. After all, if you haven’t made any sales yet, how do you determine what the value of the company is?
I have an idea for a different approach.
When I went to BaseCamp I was introduced to the “Berkus Method” of valuing pre-revenue companies, though that is not the only tool out there. The concept of the Berkus Method is simple; the company is ranked according to a handful of criteria – we used 5 – and each criteria “earns” them up to $500,000 toward their valuation. The total of those “earned” valuations per criteria is the total value of the company. If there are 5 categories then the maximum valuation would come in at $2.5M. For a lot of companies I think that might be a sufficient criteria, but there are two things that bugged me about this method.
First, some of the criteria of these kinds of methods are extremely subjective. Quality management team. Litigation risk. Potential for lucrative exit. One cannot escape some element of subjectivity in these things, but it would be nice to minimize them.
Second, not all business ventures will fit into this valuation range. I recall one of the businesses that attended the same BaseCamp I did was developing a technology that had a market potential in the billions and had already secured several million dollars in investment capital and government funding. Or, imagine a pre-revenue business that had found the cure for cancer. Niether of those should be wedged into a no-larger-than-$2.5M-valuation model, should they? On the flip side, a pre-revenue business that intended to hand-make stuffies in the owner’s garage probably isn’t going to get anywhere near $2.5M valuation, though it’s still a perfectly legitimate business.
At the end of the day what any investor really cares about is the path from where you are today to the day you are making profit. Not merely making sales, but actually making a profit on those sales. It seems to me what ought to be of paramount importance in any valuation should be the break-even analysis. For the company that is developing a massive new technology that will revolutionize some aspect of the energy sector, they might need to generate $250M in sales in order to break even on production costs, warehouse, salaries and so forth. The hand-made stuffies in the garage business might only need to generate $30,000 in revenue to break even (perhaps it’s a part-time gig).
So the baseline of any valuation ought to be the break-even point, whenever it happens and however one gets there. From the break-even analysis one can estimate the valuation at that time (which will probably be in the future!) by applying a multiplier to the revenue. Here’s where a little subjective magic takes place; what multiplier should we use? It’s often possible to get a reasonable handle on the multiplier by comparing existing, publicly traded, companies. For instance, the technology I’m developing would be comparable to something Thule might make, so I would use Thule’s financials as a starting point. From my analysis their corporate valuation is around 3X their annual revenue.
So if my company needed to generate $1M in revenue in order to break even (no, that’s not the actual number, but it’s easy to work with!) then my corporate valuation at break-even should be around $3M.
That’s the first step in my proposed pre-revenue corporate valuation process; what would the corporate valuation be at the break even point (Break Even Valuation – BEV)?
[I know that a more widely accepted model is a multiplier based on EBITA or similar – which would result in a valuation of “zero” at the break even point – so even my suggestion isn’t a perfect model either. But ask yourself this, if a company has reached break even, has market traction, and is growing year over year would you seriously say that it has absolutely zero value as a company?]
This may be a nice reference point, but this doesn’t help me figure out how to value my company pre-revenue. This is helpful when I’m generating revenue, so where’s the valuation for a pre-revenue company?
If we can agree on a future milestone called “break even” then we can begin to scale back the future valuation to a present-day valuation by asking how far are we on our journey to reaching the break even point? And it would be ideal to focus on specific, measurable, objective milestones instead of subjective estimates. Here’s what I would propose:
- You have an idea. Excellent. Get to work. Corporate valuation = 0% of BEV
- You have a functional prototype / demo piece of your software / something that shows roughly what the finished product will look like and how it will work. And – if applicable – you are at least patent pending in a number of strategic jurisdiction. Corporate valuation = 33% of BEV.
- You made your first sale. Somebody, somewhere, at arms length (your mom doesn’t count) actually parted company with their money in order to have one of your products; even if it’s just a Beta test unit. Corporate valuation = 66% of BEV.
- You sold enough units last year / quarter / month to break even. Corporate valuation = 100% BEV.
So if you haven’t generated revenue yet then your corporate valuation will be no higher than 2/3 of the anticipated future valuation of your company when you have reached break even. Based on my hypothetical $3M future BEV my company would be worth $1M when I have a prototype / patent and would be worth $2M when I make my first sale.
This is where the subjective part comes in, because we cannot escape that entirely. If I have not made a sale, but I have an executive team with strong sales experience, I have expressed interest from multiple potential customers, a strong sense of how we fit into the market, the size of the market, that we are priced appropriately etc, etc, etc. then I’m much closer to 66% BEV than I am to 33% BEV. Maybe 50-60% BEV. Perhaps, leading up to my first sale, my company might be worth $1.5M – $1.8M.
The number ends up in the same range as the Berkus Method, which is a nice confirmation. However the process is much more specific to my individual company, and is based on tangible milestones more than subjective opinions.
Strengths of this model include:
- It accounts for the actual financial realities of the specific company / technology instead of imposing arbitrary one-size-fits-all boundaries.
- It is based on specific objective milestones more than subjective opinions.
- It leaves room for subjective opinions / intangible value added without giving them too much sway.
- How likely is it that a pre-revenue company will have a solid handle on their break-even analysis? That could be as much guess work as anything else if they are very early in the process.
- It can be hard to pick an appropriate multiplier. This isn’t a show stopper, but must be kept in mind.
- With only two major milestones perhaps 33% and 66% is too coarse? Should more objective milestones be added to refine the scale?
- This model may only be useful for certain kinds of companies – technology / product / software companies.
I’d love feedback from others in the start-up scene. Drop me a line.