Rajdeep Khare

FE-01142

Bachelor of Management Studies

5-July-2022

How do Investors evaluate early stage companies?

The general definition of an early stage company is fairly simple. An early stage company

is defined as a company that has tested

prototypes, improved service models, and created business plans. Some early-

stage startups can generate early-stage revenue, but they are usually not yet profitable

therefore it is quite a trouble when evaluating these companies for the purpose of investing.

So how do a Venture Capitalist evaluate an “Early Stage Company”?

1. Founding Team

The world's most elite investors are throwing a small number of pitches every day. The most

successful start-ups are those with excellent founding team members who are working hard

to bring products from idea to creativity. To be successful, start-up founders need to be

dressed in the best technology.

“Investors naturally want to see passion, adaptability and excellent team dynamics,” says
Susan Ramott, founder of exaqueo. "Some people need a particular combination of skills,

but most importantly, most investors trying to open a wallet want to see

a previously successful team.

When assessing a start-up team, VC prioritizes the following characteristics:

Talent: The skills your team needs to succeed. Do you have the skills?

Experience: Where did your team come from?

Passion: Does your team have the courage to survive the ups and downs?

Adaptability: Is the team ready to pivot when needed?

2. Return on Investment
During the presentation of the pitch, investors want to know when the rate of return

on investment will be available. As the founder of a startup, it's your job to be proactive in

addressing these concerns. Unfortunately, many nervous start-up founders are anxious to

close a deal and overestimate their ROI when selling.

"Don't promise too much. Enter what you know, not what you think you can do. Investors

lose trust in you-that is, they see you right away." said Jordan Guernsey,

CEO of Molding Box.

To achieve a realistic ROI, start-up founders must first set realistic goals and objectives. The

best start-up founders make clear and practical plans for success. In addition, take-off

performance is regularly monitored. Did the start-up achieve an established benchmark? If

not, what do you need to do to get the start-up back on track? As start-ups grow in size, the

founders update their VCs on the latest developments. When start-up founders increase and

maintain transparency with investors, VCs feel safer about their investments.
3. Competitive Advantage

Most successful investors see competition as a positive indicator that a start-up

has entered a profitable market segment. However, it is important to show that start-ups have

their own qualifications to respond to consumer demands in an efficient and cost-effective

manner. In fact, investors are looking for a competitive advantage for start-ups in the market.

To better understand the competitive situation, start by analysing your direct and indirect

competitors. You can use Crunchbase and Similar Web to process and analyse incoming data

and trends. Use these insights to compare your goals and objectives with those of your

competitors. A better understanding of the competitive environment will help you find ways

to stand out from the crowd. Start by taking a step further into your start-up, narrowing down

to some product improvements.

"Always remember that competitors innovate on a regular basis and new

entrants disrupt the market.”

4. Momentum + Market

Most early-stage investors are looking for products and services that excite consumers.

Therefore, investors do not want to hear anything about the market potential of their products.

Instead, they want to see evidence of traction. Get ready to talk about your financial

performance, number of users, and other growth indicators during the pitch. Show investors

that they have a stable customer base, available markets, and sufficient momentum to move

forward to take their products to the next level.

Methods Investors may use while evaluating a Start-up are-:

1. Berkus Method

Named after Dave Berkus, a prominent American angel investor, the Berkus Method is a

simple method that many investors trust when evaluating startups. This method brings $

500,000 in value to five key aspects of a startup. These factors are solid

ideas, product prototypes, management team quality, strategic relationships, and initial sales.

Each of these elements is then given an arbitrary value, and the sum of them leads to a startup

rating. The determined starting price can be between US $ 2 million and US $ 2.5 million.

However, this approach is limited to pre-revenue startups only. This method is

an oversimplified evaluation method and works as an approximation.

2. Scorecard Method

To address the limitations of the Berkus method, renowned angel investor Bill Payne has

developed a scorecard method. This method uses a similar startup rating that is already

funded. Assign relative weights to many factors such as opportunity size, products /

services, technology, business stages, distribution channels, and more. And evaluate
them. The weighted average valuation is then calculated and multiplied by the average pre-

money valuation of similar startups to calculate the value of the startup company. This

method takes into account many important factors and remedies the shortcomings of the

Berkus method.

3. The Discounted Cash Flow Method (DCF)

It is one of the most widely used methods for assessing startups that are still in the pre-

profit stage. For most startups in the pre-sales stage, most of their value depends on

their revenue-generating potential. Using the DCF approach, investors evaluate startups based

on expected cash flows that the company is likely to generate in the future. The investor then

calculates the value of that cash flow using the expected rate of return on investment. This

value is then discounted against the duration and risk at the return required by the investor. In

short, DCF combines time, risk, and money to measure the value of a startup.

4. Venture Capital Method

Another way to evaluate a startup is the venture capital method borrowed from the venture

capital industry. This method is intended to evaluate the startup based on the exit value or the

exit value. The VC method takes into account revenue and other key figures from the income

statement before applying multiples to these parameters. Investors reach the exit value based

on future returns. The exit value is generally high because it does not take risk into account.

To determine the cash value, a discount rate (representing the risk associated with

the Foundation) is applied to the previously determined exit value.

5. Replication Cost

As the name implies, the replication cost method calculates the cost of

building another startup, just as it would when evaluating from scratch. All costs associated

with the development of products / services such as: B. Technology,

tangible assets, research and development with fair market value. The idea behind this

approach is that investors do not want to pay more than the cost of replication.

However, the main limitation of this approach is that it does not take into account the

potential of startups to generate future profits and returns on investment. Another drawback is

that the value of intangible assets such as brand equity and goodwill is not taken into account.

Final Thoughts

it’s safe to conclude that assessing the value of early-stage startups is never easy. Despite

challenges, specifications, and myriad influential factors, it is of utmost importance to

determine the most accurate and accurate estimate possible. Estimating high values raises

investor expectations, and estimating low values encourages owners to give investors a high

stock ratio. Therefore, it is important for both startup founders and potential investors to
calculate the most accurate valuation possible. Choosing the right way to justify a startup

idea, the market / industry to which it belongs, risk factors, and business

potential helps investors achieve fair value.