How to value early stage startups

Angel Investing
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In Angel360, our 6-week angel investing course, we deep dive into startup valuations, managing your investments and portfolio. Here’s a taste of the Angel360 and some of the topics we will cover with our guests an experienced Angel Investors from across the region. Learn more about Angel360 and apply to join the program.  

In 2013, a startup pitched a Venture Capital firm (VC) in Singapore on its B2B travel technology company.  The startup had been building out the product over the past 18 months, had some early revenue traction and had been able to convince an Angel investor to put in USD100k of capital.  The business aggregated hotel room content into one API feed so that travel agencies (online and offline) could access a much larger range of hotel rooms and pricing than they typically could through their existing suppliers, letting them offer more hotel room options at cheaper prices to their customers..  The team included a somewhat experienced entrepreneur (but with no exits), an experienced CTO with specific experience in travel tech and a previous banker with no startup experience, but with knowledge of sales and finance and who had run small businesses in the past.

How much is this startup worth?  

Well, in 2013 it closed a Seed round at a pre-money valuation of S$3.5M with revenues of several thousand dollars per month.

In 2014, after some further product development and more traction (but still not great) it closed a Bridge round of financing at a pre-money valuation of S$6.5M

Where do these valuations come from?  

Early-stage startup investment can seem extremely opaque to many outside the startup ecosystem, and in fact involves as much “art” as science.  VCs build portfolios of startups because there are so many unknowns around startup investing that the diversity helps lower the overall risk of their investments and increases their likelihood of investing in a large exit event (20x+ return on investment).  At the end of the day though, even experienced VCs are making educated guesses about the startups they invest in and the valuations they arrive at.

So, as an early-stage startup investor how can you begin to build a process to evaluate what valuation a startup might be worth?  Angel investors often invest at even earlier stages than a VC, when there is less “science” on offer.

Startup investing is not binary.

First of all, investors need to understand that investing in a startup is not like investing in a stock.  When you buy a stock, the stock then moves up or down and essentially creates a “winner” and a “loser”, with the buyer on one side and the seller on the other.  When you buy equity in a startup, you as the buyer and the founders as the seller(s), for the most part, sit on the same side of the table.  You all win or lose together.  Keep this in mind when negotiating around startup valuation and keep things fair for both sides and within standard valuation ranges.  If you as an investor take too much equity too early, the startup may be unable to raise further funding and the company may fail, which of course means you lose your investment.  

Founders also need to play by these rules: If they raise at a higher than standard valuation too early they will find it hard to raise further capital and the business will be at risk.  There is a valuation “story” that makes sense for each startup and its stakeholders need to understand this and manage it properly.

Early stage startups are valued mainly through the quality of the team, the maturity of the business and the potential for growth.

When investing in early-stage startups (I’ll use this term for startups that are “pre Series A”) a very large portion of the value of the company is held within the founding team.  You can begin to evaluate the quality of the team on topics such as:

  • Has the team built a startup before?  What did they learn from that experience?
  • Does the team have experience relevant to the industry they are operating in?  Do they deeply understand the pain point of the customer this product is selling to?
  • Does the team complement each other, and in aggregate, contain the most important skill sets and other assets needed to get this business to the next level?
  • How long have the founders known each other and is the founder relationship stable?

The maturity of the business is a bit more quantitative and can be measured through such things as:

  • Is there a product that is in front of users?  Are people paying for it?
  • How much revenue is the company receiving on a monthly basis and how much is that growing month over month?
  • Has the business received previous investment?  From whom?

Lastly, but obviously very important, is some rough estimate of how large this business can actually be.  As an example of how hard this can be, even current super-unicorn Uber presented itself as going after a much smaller market opportunity to investors than what ended up being the case.  Uber in its early pitch decks sold itself as an alternative to taxis for “professionals”.  

As we all know, Uber disrupted nearly every form of transportation, including public transportation and food delivery, and IPO’d for US$ 70 billion.  It can be very hard to get a true idea of how a startup might expand into new markets when it is two founders and a dream, but to the extent possible an expansion strategy must be analyzed for growth potential.  Some questions to ask:

  • How big is the problem being solved?  How much difference does the product make to the user compared to other options or to the status quo?
  • How many of these users are there in the home market?  How easy will it be to expand this into new markets and how big are those?
  • Who is the competition and how likely is it that this product can beat them?

Going back to the example of the B2B travel company, one of the attractions of its business model was that it was “global from day one” in the sense that the customer didn’t really need to be nearby to use the product and could gain from its use from anywhere in the world.  Early customers were distributed across Europe, Asia and the Middle East.  For many business models, however, you really want the founders to be hands on with users in the early days of product distribution so a very focused target market can be useful.  Uber initially only had several cars (that it owned), drivers that worked for Uber full time, and an extremely focused user group (young professionals in San Francisco who needed to travel in and around the city), which allowed them to gather intelligence quickly and iterate the product to respond to customer needs.  But Uber also had a clear expansion strategy: execute the same strategy in hundreds of US cities and globally.

OK, so how do I use this to create a valuation?

At Accelerating Asia we focus on a profile of startups that we categorize as “Pre Series-A”.  We define that generally as startups that have a full team, user traction (usually revenue traction as well), previous investment from third parties, but who haven’t yet closed an institutional funding round or reached product/market fit yet.  We’ve found that in South and Southeast Asia these startups tend to be underserved by the existing ecosystem structures and we help them upskill, derisk and professionalize their startups and get them access to the best institutional and other investors in the region.  So that’s our value proposition.  We only invest in Pre Series A businesses and we generally give them a valuation of between S$2 million and S$4million when they enter the program, with our goal being that they will be able to double this valuation within 12 months.  This valuation range is standard for the profile of startups that we invest in for the region.

So first, you need to determine what type of startups that you prefer to invest in and begin to understand what valuation range is appropriate for an investment at that stage.  If you are coming in as an investor in a startup that is pre-product then you may invest at S$1 million or below, whereas if there’s a product with some early users but nobody is paying yet (no revenue) then the startup may be worth between S$1-S$2 million.  These are ballpark numbers for startups in the Southeast Asia region.

I call this the Stage Method of early stage startup valuation.  This is the method the VC used in the B2B travel tech company example I used at the beginning of this article.

Determine what stage the startup is in, then use a point system to identify what part of the range it sits.

Once you determine what stage the startup is in, then you can use some of the questions above, create your own or a bit of both to start to hone in on a valuation from within the range for that stage of startup.  For clarity, let’s define a few stages and valuation ranges*:

Ideation stage: S$500,000 - S$1,000,000

  • Initial team, wireframes, deck and plan to build out first product

MVP stage(minimum viable product) - version 1.0 in front of users - no or low revenue:  S$750,000-S$1,500,000

  • Seed/Pre Series A stage:  Valuations usually between S$2-S$4M

Full team, early traction, previous investment

  • Series A stage: Valuations usually S$5M-S$15M

At least 18 months of revenue traction, product market fit emerging, ready for growth capital and market expansion

Now that we have established some general guidelines for placing startups into stages we can then start to narrow in on a valuation.  Since we at Accelerating Asia focus mainly on Pre-Series A startups let’s look at an example of how we might compare two startups within this Stage and give them different valuations within the same stage:

An investor might decide to invest in both of these companies, but based on the criteria and resulting points may want to give startup 1 a higher valuation.  Using Accelerating Asia’s valuation range for startups that are pre Series A (which these startups qualify for) of S$2-S$4 million, and inserting this number into a formula (see example at the end of this article)  an investor could value Startup 1 at around ~S$3.3 million and Startup 2 at ~S$2.7 million.  

Keep in mind that startups may have other buyers for their equity so you may need to pay a higher price.  As startup valuation methodologies focus on the team and the business they are unable to take into account outside macrodynamics, such as market rate pricing.  For instance, prior to COVID-19, startup valuations were on the high side historically due to high liquidity and a large number of new entrants into the startup investing marketplace.  Post-COVID they have reverted to more standard levels.

Before you begin building your own model you may want to read about some of the other models that have been developed, including the Berkus Method and the Risk Factor Summation methods.  Over time you may build your own custom methodology with a combination of these and the Stage Method.  And if you are investing in early stage startups then you and your founders should be familiar with SAFE notes, the easiest way to invest in startups, and used by most early-stage investors in Silicon Valley and at Accelerating Asia.  If you’re looking for some help getting started Accelerating Asia offers workshops, networking and deal flow to Angels through our Angel360 platform.  

So what ever happened to that startup we start off this story with?  The team was going through Series A fundraising and were in later-stage discussions with some global VCs with a raise of $5M at an $18M pre-money ($23M post-$) valuation.  During those discussions the team decided that they would hold off on fundraising since the business was generating positive cash flow and had plenty of money in the bank.  It was later acquired by a large Japanese conglomerate through an M&A transaction (successful exit).  

Want to learn more about angel investing? Join Angel360, our 6-week Angel Investing Course or reach out to us and we’re happy to help you learn more.

Happy investing!

Valuation Formula:

Given a 2 to 4 mil range for the pre-A stage, a 5-point company would be valued at 4 million and a 0-point company at 2 million. For Start-ups 1 and 2, we will use a range of 2.5 to 4 mil instead, given their traction with other investors. Note that you should adjust your range according to the funding environment for the relevant stage and sector.

Start-up Valuation = [ Multiplier  Range of Valuation ] + Min. Valuation for that stage

Start-up 1 Valuation: 4.25/5 x 1.5mil +2 mil =3.3 mil

Start-up 2 Valuation: 2.25/5 x 1.5 mil +2 mil= 2.7 mil

Keep in mind that this means a “0” point in any category does not mean the start-up has nothing to show for; it indicates that the team has barely made it into the stage.

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In making an investment decision, investors must rely on their own examination of startups and the terms of the investment including the merits and risks involved. Prospective investors should not construe this content as legal, tax, investment, financial or accounting advice.