When it comes to evaluating a pre-revenue startup, it’s not an easy task and there are a handful of key components to the valuation process.
Still, aside from the science involved in predicting a company’s worth, there’s still a feeling that needs to be associated. How do you feel about the potential of the industry they’re in? Do you offer a network that could accelerate their growth?
Determining a startup’s worth is more so an educated guess. But you won’t get the answer to that guess until you’ve already made the investment. A risk all of us are probably aware of but that reward could also be an a big payout as the startup grows into later stages. Here are a few thoughts to consider when determining a prospective startup and their potential value:
#1: Founding Team
It’s not uncommon for an angel investor to believe in a team more than the actual product, hence why it’s one of the more important factors.
Just as much as the idea, you’re investing in the team that plans to carry out the idea. You have to depend on them to execute the startup’s plan of action. But startup personnel can be even more valuable when including experts in the field.
It’s also best to determine where the entrepreneurs true passions are and what they can offer. An already established team could decide many factors, such as future hires, burn rate, or even how the seed funding will be used. Take into account the vision the founders have for their entity and how detailed their plan of action is 3-5 years down the road. Their expectations for their company is usually a good indicator of their expertise and ability to carry the idea out.
#2: Traction and Expected Near-Term Revenues
Traction! We hear it everyday when it comes to startups because it’s so integral in the fundraising process, especially in the seed round. Traction is a startup’s claim to value and it’s usually the measuring stick VCs use to evaluate a business’s potential or already proven growth.
Traction varies depending on the business model and the product/service, but nonetheless it shows that a startup provides value and ideally – it’ll also show the demand.
As I stated earlier, traction depends on the particular industry and business model. Although there are universal metrics that tend to hold more value above others in early stage companies:
Profitability Revenues Funding Active users Engagement Partnerships and/or Clients Traffic
There is no one rule of thumb across the board that equates your traction to a particular value. Traction varies by the model. For e-commerce companies, what’s your revenue growth so far? How many paying customers do you have and how steadily are they acquired? Those inquiries vary much differently when looking into a consumer focused tech company. With consumer focused brands, traction is more tailored towards active users, engagement, and partnerships.
Determining which traction metrics are most valuable to you depends on the business but regardless of the industry you’re involved in, investors will always back momentum.
#3: Market Size
Evaluating a startup also means that you’re evaluating the market because an opportunity is comprised of the business and it’s landscape. Analyzing market size is usually identified by the startup founders because it’s an important factor in identifying your target customer and methods of acquisition.
As you probably know, there can be a vast difference between the available market and the addressable market. The available market is the total potential revenue for the industry you’re in. The addressable market is the population you can realistically reach. Your addressable market can vary, depending on employee bandwidth, resources, funds, just to name a few factors. Obviously venture capital backing can help increase the addressable market but at what cost and how much expansion will the market allow?
How big is your market size domestically? Internationally? How fast is it growing? These are all questions you should consider when looking at this key component because they directly equate to your equity’s value.
Often, market size and competition go hand and hand. Competition can prove that a market is profitable but it can also show that a startup may or may not have a competitive advantage.
Direct competition comes from businesses with comparable products or services. Indirect competition on the other hand, happens when businesses compete for the same audience or profit opportunities but they may be in a different space in the market.
Sidecar, a competitor of Uber and Lyft, recently bowed out of the private ride race. Sidecar recently ended their ridesharing and delivery services because they didn’t have the capital to keep up with competition. Uber and Lyft may have not necessarily been technologically innovative but they surely had the financial advantage that allowed them to scale and profit quickly. Now they continue to grow their loyal customer base across the world.
As a VC, it’s imperative that you get familiar with a company’s competitors and where their advantages are. Competition can show a viable route for your product or service or their dominance could deter new competitors from entering a market.
Ultimately, competition is what makes products and services appealing for a consumer. By driving performance and innovation, while offering a wider variety of options, the consumer is at the forefront of all decisions.
Valuations are an assimilation of a variety of different factors though they tend to fall under these four areas. In most cases, it has to be a good marriage between your interests/network and the brand you’re investing in.
Good ideas can come from anywhere in the world, use these four tactics to determine if a startup will sustain and if your participation could help it grow towards that desirable exit.