Mastering the Art of Prognostication: How to Value a Startup With No Revenue

Mastering the Art of Prognostication: How to Value a Startup With No Revenue

Have you ever been out driving on a winter morning, when the fog is so thick you can barely see a few feet in front of you? Just to keep from veering off the road, you have to crawl along at ten miles an hour.

The funny thing about fog, however, is that even while it completely surrounds you in a thick layer, it’s impossible to grasp.

Estimating the value of a startup with no revenue is just as elusive. By looking at the product and meeting the team, it’s easy to determine whether or not the business has merit. But as for pinning down a precise number on its value? That’s about as nebulous as reaching out for a handful of fog and putting it into a jar.

Yet, if you’re the owner of a startup, there’s an urgent need to communicate to investors just how much your business is worth. And investors need some black and white assurance before they feel comfortable taking the risk.

Why can’t there just be a quick and easy equation, where you punch in a few numbers and viola! -An accurate appraisal comes out every time?

Unfortunately, startups without any revenue are missing some key financial metrics. And so sizing them up means looking at a lot of subjective criteria.

However, anyone who has good business acumen and is eager to do some thorough research can come up with a reasonable estimate.

Let’s take a look at just what this research entails. But first, let’s clarify some key terms, and define what a business valuation even means.

Defining Key Terms

When people discuss business and finance, a lot of similar-sounding terms get thrown around and treated like synonyms. For example, it’s easy to think that saying “this company hasn’t turned an income” is akin to saying “this company has no revenue.”

When in fact, these two statements mean completely different things!

Let’s go over a few terms to arrive at some clarity as to just what it means to talk about a “startup with no revenue.”

Revenue is how much money a business earns from selling a product or providing a service. Take a lemonade stand. Its revenue is the total amount of money it earns from selling cups of lemonade over a given period.

A profit is the money left over after subtracting the cost of goods sold from the revenue. Calculating the profit of a lemonade stand means subtracting the cost of cups and lemonade ingredients from revenue.

Income is the company’s bottom line. Calculating income means subtracting any and all operating expenses from the profit. This includes things like wages, equipment, and interest expense.

Any company with a profit or income, then, has already been in the game for some time.

A startup with no revenue, however, hasn’t even gotten out of the gate. It may have a product, and certainly has an idea for one, but until now it hasn’t sold anything at all.

And what exactly is a startup?

In the realm of venture capitalists and angel investors, a startup means a business that promises to be high growth. It’s run by a group of entrepreneurs and oftentimes posits to upset an industry.

So although the pizza place that’s just opened up down the street is a startup in one sense, it’s not the same as a high-growth startup.

A startup goes through several stages with clear demarcations, including pre-seed, seed stage, early stage, growth stage, and expansion phase.

A startup with no revenue is in a pre-seed or seed stage.

A seed stage startup, then, is like a lemonade stand that’s still brainstorming all its plans in the garage. And who, once it starts selling, intends to make a killing.

Making a Normal Business Valuation

Valuing a business, even when it’s up and running, is never cut and dry. Traditional methods for determining value lean entirely on a company’s financial statements: the income statement, the balance sheet, and the statement of cash flows.

Arriving at business’ book value uses the balance sheet. The discounted cash flow considers a company’s net cash flow (found on the statement of cash flows) and overall risk to arrive at valuation. Another method for calculating value considers a company’s revenue and earnings (found on the income statement) alongside an industry standard.

All this is to say, using the established methods, it’s impossible to make a business valuation without financial statements.

A startup with no revenue, as we discussed, isn’t selling anything at all, and so it cannot generate financial statements. Trying to make a traditional business valuation of a seed stage startup, then, is like trying to bake bread without any yeast, salt, or flour.

Calculating the value of a business without any revenue means jettisoning these established methods. It entails approaching business valuation from a completely different point of view.

Finding the Goose to Lay the Golden Egg

Back in 2007, at the South by Southwest film and music festival in Austin, a team of Silicon Valley entrepreneurs made an auspicious showing.

Their recently-developed product was the brainchild of months and months of scheming. After scrapping podcasting ambitions, the small crew forayed into the realm of text messaging.

Spending only eleven thousand dollars, they rented several large screens, and positioned them in hallways throughout the festival, displaying 140 character messages onto them.

People walking between music performances took note, and enthusiasm for the product started to crackle. Attendees communicated with each other in messages such as: “I see other people using Twitter in the audience… identify yourself! ;)”

The foursome became the buzz of South by Southwest that year, receiving the “Best Blog Startup” award. And their micro-blogging service started to take off. The overall number of tweets tripled that weekend, and the concept of hashtags was born.

Notwithstanding the enthusiasm, how could any investor witness this unveiling and foresee that Twitter would become the monolith it is today: a social media platform with 330 million users, and a company with a net income of over a billion dollars?

What did investors look at to determine Twitter’s value, lacking any financial statements? How did Biz Stone, Jack Dorsey, Noah Glass and Ev Williams pitch the significance of their business, when nothing had even been sold?

Let’s look at some of the criteria that determine the value of a startup with no revenue.

1. The Team

We’ve all seen those companies on Shark Tank with a brilliant product but the wrong person at the helm.

Even more than the product or service, an investor assessing a startup takes a close look at who comprises the team.

“Older entrepreneurs with a lot of DNA in the vertical that you’re attacking, with a really good network, get a higher mark than somebody who comes in off the street with the same idea,” says Jeffery Carter, a general partner at West Loop Ventures.

A dedicated, scrappy team has the potential to deliver a powerful product and upset a market. When an investor loves a team, he or she is much more willing to support the enterprise.

Some things an investor looks for in a team include:

• Experience in the industry.
• Leadership experience such as a CEO and CFO.
• Product Management experience.
• Willingness for the leader to step down and allow someone else to be the CEO.
• A leader with a sound team in place.
• Technology experience.

Some red flags to look out for include:

• A solo entrepreneur with no management team.
• An unwillingness to be coached.

This character assessment is largely based on intuition. And leading with our gut sometimes goes south.

Take Softbank investor Masayoshi Son. After demonstrating a penchant for identifying and supporting the most up-and-coming, he became enamored with none other than WeWork founder Adam Neumann.

And we all know how that story ended. WeWork’s attempted IPO ended in epic and humiliating failure, when its SEC filing failed to entice investors and generated peals of laughter across the nation (it dedicated the S-1 to the “energy of we” and stated that its mission was to “elevate the world’s consciousness”). Neumann eventually resigned from his position as CEO.

In sum, a team is integral to a startup’s value. But sizing up a team is pretty subjective and certainly not foolproof.

2. Size of the Market

The market into which a startup launches also determines its value.

A company who makes an auspicious debut into an enormous industry such as pharmaceutical drugs would probably have a higher value than, say, Ping, which is a startup that provides a timekeeping method for lawyers.

3. Impact on the Market

It’s also important to understand how a startup positions itself within an industry.

A product dependent on another company’s software is weak and tenuous. When the company updates its software, the business is over.

However, a product or service that really upsets the existing paradigm could have tremendous value.

Take Uber, for example. It launched into a market dominated by taxis, and offered the same service using a very different method. People ordered rides from their phone, and nearly anyone could become a driver.

Airbnb, as well, turned the lodging industry on its head. Whereas hotels and bed and breakfasts formerly had exclusive reins on the market, Airbnb allowed anyone and everyone to offer their spare bedroom or basement as a destination for travelers.

Both these companies eliminated middlemen and created entirely new markets within the industry. They started a trend and they aren’t going away anytime soon.

In order to understand how a product will impact an industry, it’s important to acquire domain knowledge and talk to people.

Identifying current trends also plays a key role.

Take Substack, for example. Its model of subscription newsletters came along as journalism jobs were on the decline. Yet, everyone was still committed to checking their emails every single day. They spotted a need in the market and filled it.

4. Companies With Similar Products

Trying to evaluate a startup with no revenue is a little like looking at a puppy and determining what he’ll look like when full grown.

In order to arrive at greater certainty around all the unknowns, it’s helpful to look to animals of the same species—or, that is, similar startups at the seed stage.

By researching similar businesses and understanding any obstacles they faced, it’s easier to make an accurate prediction about a given startup.

5. Customer Feedback

When Twitter became all the rage at South by Southwest, with new users excitedly punching in messages and creating personal hashtags, it no doubt sent some wake up calls to a few investors.

A startup is looking for validation at the seed-stage, and the best way it can find this is through the way a customer reacts to a product.

It sometimes happens that a startup is so progressive that the market isn’t yet ready for it. Take the company Uico, for example. When they started rolling out touchscreen technology around 2007 and 2008, the very first iPhone had only just come out. Everyday people at the time had no capacity for using touchscreens.

Fast forward eleven years, and most of us use this technology every day.

This is to say, the end user provides a strong indication of a product’s value. However, it’s also important to have domain knowledge about the industry. It may be that the business will be viable within a short time.

6. Product Evaluation

Taking a good hard look at the product itself naturally is central to understanding the value of a startup.

When evaluating a product, it’s important to take into account things such as:

• Is the product easily duplicated?
• Is the product in its final form? Or is it a prototype?
• Does the product have patent protection?
• Does the product have strong competition?

It’s also important to understand if a team is willing to pivot. As it so often turns out, the end user reacts quite differently to a product than anticipated, and so major tweaking is usually part of the game.

7. Entrepreneur’s Pitch

The team plays a large role in determining the value of its product and company.

In order to secure smart money, the team educates the investor about the value of the product. An effective communication strategy enhances the startup’s value.

It’s important for the team not to overvalue itself, however, as that could make it difficult to secure more financing during the next stage.

As you can see, identifying the value of a startup with no revenue entails quite a bit of research.

Much of the criteria is subjective. Even with in-depth knowledge about a particular industry, different people arrive at completely different assessments of a product’s risk and potential.

Valuing startups requires being proactive. Greater knowledge about a team, the product, and the industry increases the likelihood of making an accurate valuation.

Putting a Number on It

We just looked at various criteria to use when valuing a startup with no revenue. But what about arriving at a precise number? How would someone, say, put the value for a given startup at $5 million rather than $10 million?

Determining a precise number is more art than science.

The methods are nothing like those used for evaluating most companies, where financial statements provide solid numbers.

Arriving at a value for a startup with no revenue is more about putting quantitative values onto qualitative evaluations.

Here are two methods for estimating the dollar value of a startup without any revenue.

1. The Scorecard Method

The scorecard method compares a seed-stage startup to other startups of a similar size, with a similar product, and at the same (or nearly the same) stage in the startup journey.

A. How to Calculate

The first step in the scorecard method is to determine the median pre-seed valuation of similar companies within the region. Let’s say this valuation is determined to be $5 million.

Next, evaluate the target company according to a list of weighted criteria. The importance of each item is reflected in how it’s weighted against the others. Here’s one possible breakdown:

• Team: 30%
• Size of the Market: 20%
• Product: 15%
• Marketing: 15%
• Competitive Environment: 10%
• Other: 10%

(Items on the list and their designated weights can be adjusted.)

The next step entails looking at each category, and determining how the target company stacks up against its competitors.

For example, if the startup has an exceptional team, it’d receive a score of 150% in the “team” category. If the product isn’t so good, it scores “70%” (or so) for this category. If one category is about the same as competition, it receives a weight of 100%.

Now, the values in columns 2 and 3 are multiplied to reach the value in column 4. These products are then added up to reach a final sum, which in this case is .965.

This final sum (.965) is multiplied by the median pre-seed startup value ($5 million). In this example, we arrive at a startup valuation of $4.825 million.

B. Analysis

The scorecard method accentuates the enormous impact a team has on a startup’s success.

An experienced, flexible and collaborative team can navigate the many challenges a startup faces, and so a great team is more important than a great product.

A weakness of this method is that all the estimates are subjective. One investor may well arrive at a very different valuation than another, and there’s no telling who is right.

2. Risk Summation Method

Valuing a startup is all about asking “Will this product be successful? And if so, by how much?” The flip side to estimating success is evaluating risk.

The risk summation method seeks to systematically evaluate and measure all the various risks a company faces, and in doing so determine the company’s overall value.

A. How to Calculate

The first step with the risk summation method is the same as the scorecard method: determine the median value of other similar startups in the region, with a similar product and at a similar stage. Again, let’s put this value at $5 million.

The next step is to come up with a summary of all of the risks associated with startups, and the target company in particular. A possible looks like this:

• Management Risk
• Capital Raising Risk
• Startup Stage Risk
• Sales and Marketing Risk
• Manufacturing Risk
• Legislation Risk
• Reputation Risk
• Technology Risk
• International Risk
• Exit Risk

Next, carefully research the company, the industry, and the team. Then weigh the risk for each category by assigning it a negative or positive value between -2 and 2. A negative value means high risk, while a positive value means low risk.

Next, multiply each “Risk Rating” by $250,000. Then, add together all the values in the third column.

Finally, we take the sum from the third column and add it to the median startup value. In this example, we add $250 thousand to $5 million to reach a final value of $5.25 million.

B. Analysis

The power of the risk summation method is that it judiciously examines and weighs all known risks. It’s easy to, say, overlook the legal risk a product poses if you’re super enthusiastic about the product and the team.

Again, the estimations are really subjective, and can vary widely.

And finally, it’s probably clear that this $250 thousand value needs to be scaled. For example, $250 thousand is quite a different beast for startups valued at $20 million than those valued at $2 million. So one gauge would be to make the “point” value equal about 10% of whatever value you determine the average startup value to be.

In sum, you can’t exactly cut the goose in half to see if there’s any gold inside of it. All of these methods for evaluating a startup at the seed stage are helpful, yet highly subjective.

Startup valuation, in many ways, comes down to projection, conjecture, and trusting your gut.