How do you value startups and spin-offs pre-revenue in 2024?

Startup valuation is a critical topic for any founder seeking initial investors. The biggest challenge arises from the fact that an early-stage startups face numerous risks in product, market, and team dimensions. As a result, financial projections often serve more as a demonstration of ambition than a precise financial science. To address this challenge, venture capitalists apply several valuation methods that are independent of a startup’s financial projections. Here, we explore three widely used methods:

1. Payne Scorecard Method

2. Comparable Transaction Method

3. Cost-to-Duplicate Method

Payne Scorecard Method

The Payne Scorecard Method is a relative valuation approach that compares the target company to a set of startups similar in stage, geography, and industry. This method considers qualitative factors, such as the strength of the management team, the size of the opportunity, the product or technology, competitive environment, marketing, and sales channels.

How It Works:

1. Identify Similar Startups: Select a set of comparable startups in the same stage, geography, and industry.
2. Assign Weights to Factors: Assign weights to various qualitative factors that influence the startup’s potential, such as management team (30%), size of opportunity (25%), product or technology (15%), competitive environment (10%), marketing (10%), and sales channels (10%).
3. Score Each Factor: Score the startup on each factor relative to the comparables.
4. Calculate Weighted Score: Multiply the score of each factor by its respective weight and sum them up to get a total score.
5. Determine Valuation: Apply the weighted score to the average valuation of the comparable startups to determine the startup’s valuation.

Example:

• Comparable Startups’ Average Valuation: $2 million
• Management Team Score: 8 (out of 10)
• Size of Opportunity Score: 7
• Product or Technology Score: 6
• Competitive Environment Score: 5
• Marketing Score: 6
• Sales Channels Score: 7

Weighted Score Calculation:

• Management Team: 8 * 0.30 = 2.4
• Size of Opportunity: 7 * 0.25 = 1.75
• Product or Technology: 6 * 0.15 = 0.9
• Competitive Environment: 5 * 0.10 = 0.5
• Marketing: 6 * 0.10 = 0.6
• Sales Channels: 7 * 0.10 = 0.7

Total Weighted Score: 2.4 + 1.75 + 0.9 + 0.5 + 0.6 + 0.7 = 6.85

Valuation: 6.85 / 10 * $2 million = $1.37 million

Comparable Transaction Method

The Comparable Transaction Method is another relative valuation approach and is often the simplest method. It involves taking the average valuation of a set of startups similar in stage, geography, and industry.

How It Works:

1. Identify Comparable Startups: Find startups that are in a similar stage, geography, and industry as the target startup.
2. Determine Valuation Multiples: Gather data on the valuation multiples from recent funding rounds of these comparable startups.
3. Calculate Average Valuation: Use the average of these valuation multiples to estimate the target startup’s valuation.

Example:

If the average valuation multiple for comparable startups is $5 million, then the target startup’s valuation would be approximately $5 million.

Cost-to-Duplicate Method

The Cost-to-Duplicate Method calculates the theoretical value required to rebuild the startup from scratch. This approach considers the time and resources necessary to recreate the startup, making it mainly used by strategic investors, such as established companies, when making a make-or-buy decision.

How It Works:

1. Estimate Development Costs: Calculate the total cost of developing the technology, product, or service from scratch, including R&D, salaries, and other operational costs.
2. Add Intangible Assets: Account for intangible assets such as intellectual property, brand value, and customer base.
3. Sum Up Costs: Sum up all these costs to get the estimated value.

Example:

• Development Costs: $500,000
• R&D Costs: $200,000
• Salaries: $300,000
• Operational Costs: $100,000
• Intangible Assets: $400,000

Total Cost-to-Duplicate: $1.5 million

Practical Application and Considerations

Valuing a pre-revenue startup is more art than science and requires a deep understanding of the industry, market potential, and the startup’s unique value proposition. Here are some practical considerations for each method:

Payne Scorecard Method:

• Advantages: Provides a structured approach to account for qualitative factors. Useful for early-stage startups where hard data might be limited.
• Disadvantages: Subjective scoring can lead to variability. Requires a good understanding of the industry and comparables.

Comparable Transaction Method:

• Advantages: Simple and quick. Provides a market-based valuation.
• Disadvantages: Relies heavily on the availability and accuracy of comparable data. May not account for unique aspects of the startup.

Cost-to-Duplicate Method:

• Advantages: Grounded in actual costs. Useful for strategic investors evaluating build vs. buy decisions.
• Disadvantages: May undervalue startups with high growth potential. Doesn’t account for market dynamics or future potential.

Conclusion

Valuing pre-revenue startups and spin-offs involves navigating uncertainties and making informed estimations based on qualitative and quantitative factors. By understanding and applying methods like the Payne Scorecard, Comparable Transaction, and Cost-to-Duplicate, founders and investors can arrive at a more reasoned and defensible valuation. Each method has its strengths and weaknesses, and often, a combination of these methods provides the best insights into a startup’s true value. As the startup progresses and begins generating revenue, these valuations can be refined with more concrete financial data, guiding both strategic decisions and investor relations.