To the untrained eye, evaluating an early stage company can be as ‘airy’ as evaluating a piece of artwork.

According to Artnet:

Like currency, the commercial value of art is based on collective intentionality. There is no intrinsic, objective value (no more than that of a hundred-dollar bill). Human stipulation and declaration create and sustain the commercial value.

A similar sentiment can be felt towards evaluating companies at the pre-seed stage. With hardly any traction, a working prototype or tangible metrics, value creation can be quite sticky.

In this article we’ll be highlighting the different methods you can take to arrive at the most accurate valuation for your start-up and how you can justify the numbers to your investors.

To begin, let’s explain exactly what we mean by company valuation. According to Investopedia:

Valuation is a quantitative process of determining the fair value of an asset or a firm. In general, a company can be valued on its own on an absolute basis, or else on a relative basis compared to other similar companies or assets.

There are multiple (and sometimes tedious…) ways you can go about quantifying how much your start-up is worth.

When you’re determining your start-up’s value for the sole purpose of pitching and raising funds, the method you would take largely depends on the the type of investor you will be pitching to.

Some investors look at early valuations as more of an art than a science but there truly is no other substitution for being able to justify your figure with fact-based analysis.

Here are the three popular, data-driven methods you can use:

1) Market multiple approach

A method preferred by VCs, the market multiple approach compares your start-up’s value against that of similar recently acquired companies.

Investor’s like this approach as the estimate gives an accurate indication of how the market values the company and how much it will be willing to pay.

However, a downside to this is that finding comparable market transactions can be quite difficult for early stage start-ups.

2) Discounted cash flow analysis

For quite early stage start-ups (those who haven’t started generating revenue yet), investors predict value by forecasting the company’s cash flow.

Discounted cash flow (DCF) analysis involves forecasting future cash flow and using the expected rate of investment return multiplier to calculate how much that cash flow would be in the future

One thing to note is that the quality of the DCF depends on the forecaster’s ability to predict future market conditions so after a certain number of years, there is a level of guess play involved.

3) Valuation by stage approach

A method most commonly used by angel investors is the valuation by stage approach.

This is where investors come up with a start-up’s value based on which stage it is at in its commercial development.

The standard consensus is that the further a company has developed its product, team and strategy, the less risk associated in investing in it and the higher its value:

As the company climbs up the developmental ladder, it will establish itself within higher value categories amongst investors.

However, as highlighted by Forbes, it’s extremely important to not over-inflate valuations as there could be a chance that your next round could be a down round.

To conclude, if you are pre-product, it can be difficult to assess with a high degree of accuracy your company’s valuation with no traction or revenue figures to fall back on.

Hopefully, this article has demystified the different methods both start-ups and investors use to calculate valuations and has provided a useful blueprint to follow along your start-up’s raise journey.