How to conduct a post-money valuation, the right way

Conducting a post-money valuation is more or less a matter of ‘rough’ calculations, estimations, extensive market research and negotiations. All of these steps are, most of the time, essential till both parties — investors and startups — finally come to an agreement. And though the whole process is indeed based on projections, the question still remains; what is the right way to conduct a post-money valuation?

How to conduct a post-money valuation, the right way

We’ll try to answer that question, with a walkthrough on some of the known valuation methods that help investors shoot on target, in terms of post-money valuation. Or, at least, as close as possible.

Let’s start with the basics and set the context for all of our readers, first.

Things you need to know about startup valuation

Experienced economist, practitioner investor, startup founder or just a newcomer to the startup world, you definitely need to know what post-money valuation is. Getting to know or just reviewing relevant terminology is always helpful. 

With that in mind, let’s present you with a sort of an FAQ on startup valuation; one that will work as a foundation for our discussion.  Let’s start with the major term that is the main focus in our article; post-money valuation.

What is post-money valuation?

According to Investopedia:

It’s the approximate market value given to a startup once a funding round has been completed.

And since a definition alone is not quite helpful let’s examine a few more things.

What exactly is the valuation of a company — startup or not?

Company valuation is a way to determine the economic value of a business. On a hypothetical — or not — scenario of selling the company, the output of this calculation or estimation would be its value.

This action of valuing a company is needed in several situations. For startups, to be more specific, it might be the fact that there’s a need for funding; as it usually happens. In particular, investors will buy a percentage of ownership; a seat  in the company, in exchange for the capital investment. And the terms of the final agreement will be based on that particular estimate: startup’s economic value.

So, though company valuation is, more or less, an estimation by its very nature, it’s still a determining factor for this financial contract between startups and investors.

What are the factors that affect the output of the valuation process for startups?

Some of the parameters that shape this value — but are not limited to — are:

  • the industry in which a startup trades
  • the location and
  • the stage of the startup

Tech companies, as expected, are often valued higher than other types of companies. In the same fashion, in competitive geographies such as Silicon Valley, valuations “soar quickly” as Mahendra Ramsinghani aptly puts it in The Business of Venture Capital. And that, of course, translates into lost opportunities for investors that probably pay no attention to startups located in “unpopular” areas; startups that probably have the potential to grow and scale

Does this sound familiar to you? Well, if your startup is located in the East Mediterranean, for example, you’re probably already aware of how things work in these areas. In the same fashion, if you’re an investor, you’re probably familiar with the skepticism perhaps you, yourself, had to deal with, when you laid a relevant suggestion on the table for your partners to discuss further.

Now let’s focus on the startup stage and how that affects the valuation process.  

How startup valuation differs per growth and funding stage?

Let’s start with the growth stage of a startup and how that affects the valuation process. 

As expected, early stage and growth stage startups are worlds apart. The latter have collected measurable data, upon which valuations can be based. But, for early stage startups that have no or limited data, the whole process can, at best, be an educated guess. Most of the time, early stage startups have no customers and consequently no traction and no revenue data. They only have a prototype or an MVP on the development stage to demonstrate. Under these circumstances it is quite difficult for investors to make estimations on its potential for success; and consequently try to mitigate the risk associated.

Does that mean that valuation remains just a theoretical exercise of sorts? Yes and no. In particular, for post-money valuation that takes place once a startup company has already received funding, there are a few widely accepted methods that help investors get a greater sense of its value — or potential if you wish. And that’s exactly what we’re going to examine next.

Conducting a post-money valuation

Below we present an overview of a few representative methods used by angel investors and VCs when conducting startup valuations.

The Berkus Method

It was defined by David Berkus, an active angel investor. And it has become a useful tool for investors and entrepreneurs looking for a simplified way to value a pre-revenue startup. According to Berkus, lengthy revenue forecasts failed to offer an accurate estimation; and thus, a method that would allow them to focus on core startup parameters would be more useful. His approach focuses on the following five startup components, rating them with a maximum value of $500k in mind.

  • sound idea
  • prototype (reduces technology risk)
  • team (reduces execution risk)
  • established strategic relationships (reduces market risk)
  • product rollout and sales (reduces production risk)

The method was recently updated; you may find more information here

The Scorecard Method

The Scorecard method is considered one of the most popular methods angel investors use when conducting valuation of early stage startups. This method focuses on a list of startup parameters that they, then, rate accordingly. The difference here is not in the parameters examined, rather than the fact that, this time, the scoring takes into account a group of competitor startups trading in the same industry. In particular, the target startup is valued on each one of the following parameters:

  • team
  • size of opportunity
  • technology/product
  • competitive market environment
  • sales & marketing
  • need for additional funding
  • other extra parameters

Here is an extensive reference that describes this scoring method in detail, as written by Bill Payne.

The Risk Factor Summation Method

The idea here, similarly to the previous methods, is you focus again on assessing against a list of parameters that add risk to your venture. More specifically, and simply enough, you assign positive, negative or neutral risk weights on the following parameters; and then weigh the results: 

  • Management Risk
  • Stage of Business
  • Legislation/Political Risk
  • Manufacturing Risk
  • Sales and Marketing Risk
  • Funding/Capital Raise Risk
  • Competition Risk
  • Technology Risk
  • Litigation Risk
  • International Risk
  • Reputation Risk
  • Potential Lucrative Exit Risk

The Venture Capital Method 

The Venture Capital Method — or the First Chicago Method — is an approach venture capital and private equity investors use, for the most part. According to Bill Payne:

(This method) is all about projecting a future state and then working backwards from there to derive your required valuation.

And it offers that projection for those that prefer a quick and rough calculation of a startup’s value. That is, without taking into account way too many input sources. 

The idea is simple and it’s expressed in the following equations: 

Expected Return on Investment (ROI) = Exit Value / Post-money Valuation

Post-money Valuation = Exit Value / Expected Return on Investment (ROI)

You may find more information about this method here.

How to use post-money valuation methods the right way

In researching how to conduct a post-money valuation, to help minimize your risk as much as you can, you’ll find plenty of suggestions. In particular, you’ll come across different perspectives on the issue, followed by the respective methods to choose from. However, all authors of related articles or books, such as the ones we’ve cited above, agree on one thing:

Post-money valuation for pre-revenue startups and for those that have a growth stage are completely different.

Allow us here to list a few tips on how to approach post-money valuation, in both cases:  

The pre-revenue game

Post-money valuation for pre-revenue startups is, more or less, guesswork — for the brave ones. And that’s because no Excel spreadsheet is good enough to help conduct a post money valuation for a pre-revenue startup. And, in case you totally missed my point of argument, there is no such thing as Excel spreadsheets or calculators or algorithms; or anything that will help. So, in this case you’ll need to base your valuation on estimation, using parameters such as industry, idea, startup team and many others; as described in the methods aforementioned.

When numbers help your way: post-revenue valuations

When working with post-revenue startups, you’d better use a blend of methods to make your post-money valuation. And, especially when the size of your impending investment is extremely important in terms of amount of capital, then target the kind of ownership — type and terms — that best serves your interests. The same goes if you “sense” there are additional competitors in the game. Just because they’ve managed — or claim so — to attract other investors, it doesn’t mean that you have to act with haste.

As Jeffrey Bussgang warns in the Mastering the VC Game

If the entrepreneur has numerous VCs chasing them, they can drive up the price

So, do your homework; make sure your negotiation is worth the risk and it’s not just a bubble about to burst.

Wrapping it up

If you’re still wondering whether there’s a formula for post-money valuation or if you’re trying to come up with your own, the answer is simple. You need to focus on a blend of factors, such as

  • team
  • market
  • size of opportunity
  • sales & marketing
  • strategic relationships

And though there is no mathematical equation that will give you a fixed output to help minimize risk, what will help is past experience. Firstly yours; and then your team’s — as investors — since you’ll have a deeper understanding of the market and the world of startups, in general. Additionally, of course, a startup team’s experience will help everyone avoid stumbling upon trivial obstacles. And, also, be crystal clear on their mission.

At the end of the day, apart from strategies, it’s the people that make success stories happen. And as Lorenzo Carver says in his book Venture Capital Valuation:

Financial, strategic investment and even speculative “value” had everything to do with “who” involved. […] Without analyzing and appreciating who, the most financially attractive opportunity could be destroyed by a single individual.

How to conduct a post-money valuation, the right way was last modified: October 30th, 2020 by Konstantina Ferentinou
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Konstantina Ferentinou

The Starttech Ventures Content Marketing Writer. Studied Computer Engineering and Informatics at the University of Patras. She has working experience in technical writing, sales and support related roles. She now focuses on content creation. Channeling her creativity into writing, she hones her ability to communicate the right message through various content types.