All manner of confusing euphemisms pop up in various contexts. So you shouldn’t be surprised when you hear about pre-revenue companies.
Young companies in the early stages of their development sometimes want to get an appraisal. For example, business owners may need to reach out for external funding or address issues such as deferred compensation for key employees under the Internal Revenue Code Section 409a.
Now you probably know that business value rests on the company’s ability to produce adequate returns. After all, why else would you form and run a company?
However, lack of financial track record should not stop you from putting a value on a company. How to do it?
Most importantly, business value depends on the expected future earnings. Even for an established company, past returns don’t count. Unless, that is, you can use the company’s financial track record to predict the future.
Create a realistic financial forecast
As a result, you should first come up with a financial forecast. But how can you do it in the absence of historic track record?
Time to delve into the company’s business plan and check out those pro-forma financials. Usually, financial models start with an assumption that revenues will materialize at some future point.
So now you know what the company’s management expects to see in terms of sales. Next, you can forecast the business expenses as a function of revenues, usually a number of years into the future. And that fills out your income statement forecast.
You can handle your balance sheet modeling similarly. Again, you estimate the assets and liabilities as a function of expected revenues.
To close the forecasting model, you need to pick a plug. That’s what financial gurus call it. The plug makes sure your financial forecasts work. For example, you can choose the owners’ equity as the plug. In other words, you make sure this balance sheet identity holds true:
Owners equity = Total business assets – Total liabilities
Picking the valuation methods for pre-revenue company valuation
Now you can decide on the methods to use to figure out the company’s value. As usual in business valuation, you can pick quite a number of such methods under the asset, income and market approaches. But which ones really work for pre-revenue companies?
Market comparisons can’t help much here. That’s because most private businesses that sell have a solid track record of earnings. Business buyers want to pay for companies that put money in their pockets right away. So comparing your pre-revenue company to such established firms doesn’t work well. Apples and oranges.
Asset based methods don’t sound too appealing either. It takes successful companies quite a bit of time to figure out how to optimize their asset base for peak profitability. So your pre-revenue company has its work cut out for it.
Unless, of course, business owners plan to sell their assets rather than creating a going concern company. This could be the case if the owners decide to sell some attractive piece of technology or know-how to a well funded business buyer. Think of early stage high tech start-ups that get gobbled up by large public companies.
Your best bet – income based valuation
So this leaves you with the income based valuation methods. The good news is, such methods help you figure out the business value based on the future expectation of returns and risk assessment.
Indeed, you have a good financial forecast. Next, you can assess the company’s risk in the form of discount and capitalization rates. To complete your valuation, pick the discounted cash flow or capitalized earnings methods. Both let you figure out your business value based on expected earnings and risk.