Recently we were hired by an entrepreneur to raise funds for him. The only issue was that it was a pre-revenue company which had just perfected its technology and finally created a commercially viable prototype.
The entrepreneur had met a few potential investors but could not seal the deal with them.
Was the idea great? Indeed. Was there proof of concept? Yes. Was the technology path-breaking? Of course. Then, why was he not being able to raise funds?
Whenever he was asked how much equity he would give up for the funds required, he had a vague figure in mind but was not convinced himself about how much was his idea and effort that he had put into making it commercially viable, worth. Neither did he understand how much the money being invested was worth. He was not good at negotiating and thus all investment conversations were ending in a stalemate.
In this article we will try and help this entrepreneur and others like him by explaining a popular and simple method Venture funds use to value pre-revenue start-ups. This will help those looking to raise funds understand what they need to focus on building in terms of capabilities. It will also help investors find a logical way to assess start-ups and whether they should invest in them. Needless to say, while the method is logical, it is highly subjective but then given the risk taken by investors, this is something that is bound to happen.
The method is referred to as the scorecard method developed by Bill Payne. The method basically compares one startup with the average pre-money valuation of other funded start-ups. The first step is finding the average of pre-revenue startups. Once this is established, the next step is to compare the perception of the target startup with others based on the following factors:
The strength of the management team - Max 30%
Size of the opportunity - Max 25%
Product/Technology - Max 15%
Competitive environment - Max 10%
Marketing/Sales/Partnerships - Max 10%
Need for additional investment - Max 5%
Other factors (customer traction, feedback, etc.) - Max 5%
The good thing about this method is that it gives significant importance to the team, so if the idea is good and is backed by a good team, it is bound to rank high with investors.
Understanding this method is critical for startups to know how to negotiate equity stakes and valuations with investors.
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