This week, I want to talk about pre-revenue startups, because people keep asking me how to value them.
What Is (and Isn’t) a Business
If you’ve followed me for a while, you know my rule:
To be a business, you need people, capital, and a place—all working together to produce cash flow.
A pre-revenue startup has none of that last part. There’s no cash flow yet.
Instead, investors are pouring money into an idea, hoping that one day it will produce revenue and a return on investment.
That makes it risky—very risky.
It’s like funding an oil exploration company: you spend money drilling holes, and if you don’t hit oil, all that time, energy, and capital just disappears.
So How Do You Value a Pre-Revenue Startup?
Let’s look at an analogy.
If I went out and bought a dump truck, a backhoe, and some wooden forms to build house foundations, and parked them all in my yard, what would I have?
I wouldn’t have a business yet—but I’d have a pre-revenue startup foundation company.
If I wanted to sell it before I ever got my first customer, would it be worth something?
Sure—it would have liquidation value, based on what someone else would pay for the equipment.
That’s the same principle that applies to startups that have built technology, software, or intellectual property.
The Principle of Substitution
Let’s say a big company spots your startup and says,
“Wow, if we had this widget inside our existing platform, we could make a ton of money.”
They can see the value in your technology—but you don’t have any revenue yet.
What happens next? They apply something called the principle of substitution.
They ask:
Could we build something similar ourselves?
How long would it take?
How many people and how much money would we need?
If they estimate it would cost them, say, $500,000 to build, they might offer to buy your startup for less than that, because it saves them time and risk.
They might even offer slightly more if they can see that your solution already works, since building it themselves could introduce delays or surprises.
But ultimately, the value comes down to what the acquirer thinks it’s worth to them, not what you think it’s worth based on “potential.”
The Harsh Truth About “Potential”
Startup founders often say,
“Yeah, but look at what this could become!”
And that’s when I point them to another concept I’ve covered in my videos: Blue Sky.
Blue sky is the imagined, hopeful future value that might exist one day—but that nobody will pay for today.
The reality is that when a larger company acquires your startup, they’re not paying for your potential.
They’re paying for what they can do with it themselves.
The Bottom Line
The valuation of a pre-revenue startup is really just a combination of:
Liquidation value (what your assets are worth today), and
Substitution value (what it would cost someone else to build the same thing).
Everything beyond that—“potential,” “vision,” or “what this could be”—is blue sky.
It’s speculative, and in most cases, it’s worth exactly zero until real, repeatable cash flow appears
Learn How to Buy or Evaluate a Business the Right Way
If you’re serious about buying a business, check out my online course at BusinessBuyerAdvantage.com.
Don’t waste your hard-earned money chasing dreams and “potential.” Learn to evaluate businesses the right way before you buy.
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Cheers,
David C. Barnett.
