Startup Valuation Methods

What Are Startup Valuation Methods?

Startups are new business endeavors. The people who begin these ventures are called entrepreneurs. They typically focus on creating new goods or services and introducing them to the market. These could be original concepts or technologies.

Startups don't have a long history of revenue, cash flow, or earnings (if any), so a large portion of the valuation is decided by comparing with similar companies in the marketplace and comprehending how the industry for a particular type of startup values the companies within it.

A startup valuation is an estimation of the value of a startup company to aid in the financing, management, and sales. In addition, evaluating the new company's risks and expected growth rate can help predict its future value.

A simple framework for decision-making is frequently used in the valuation process, which also involves researching other businesses like yours. Startups just getting started and requiring direction when making strategic decisions benefit from the valuation.

According to renowned economists and finance gurus, valuation is both an art and a science.

The science is straightforward: determining comparable company valuations and creating multiple EBITDA or revenue. The art is more arbitrary. How capable is the group? How likely are the leads currently in the pipeline? What is the level of innovation of the existing technology?

Today, hundreds of companies with unicorn valuations are valued at $1 billion or more. Nowadays, there are "hectares," startups valued at over $100 billion, and "decacorns," at $10 billion.

Why is the valuation required?

Investors may want to determine their potential return on investment. Likewise, entrepreneurs may wish to compare their costs and revenues to see if they are making a profit, so estimating a startup's value is critical.

This is one of the more challenging tasks for any entrepreneur. However, it's also one of the most important for any business to choose where and how to spend its time and money most effectively.

A startup's valuation may consider things like (and more):

• Your team's skill set
• The product
• The assets
• The business model
• The total addressable market
• The performance of its competitors
• The market opportunity
• Goodwill

You can use specific economic data as a starting point if you have actual revenues. But when it comes to fundraising, your company's value ultimately depends on what you and your investors think it is worth.

Consider the value beyond money before specifically considering the monetary value of comparable businesses. Make sure you are not overvaluing or undervaluing your company.

There is no one widely accepted analytical methodology for investors because a lot of startup valuation depends on speculation and estimation.

Instead, VCs and Angels will use various venture capital valuation techniques to determine a business's pre-money value—how much it is worth before they invest—before investing. Moreover, Venture capital valuation is a method used by VC firms to assess the potential return on investment for a start-up company.

Pre-money valuation is the value of a firm before any outside capital or a most recent round of funding has been added. Conversely, post-money refers to the company's value after receiving funding and subsequent investments.

Valuation is challenging for startups with little or no income or profitability and uncertain futures.

A mature, publicly traded company's earnings before interest, taxes, depreciation, amortization (EBITDA), or other industry-specific multiples are typically used to determine the company's value.

However, valuing a startup that is not publicly traded and may take years to generate revenue is much more difficult.

Startup Valuation Methods

Startup Valuation is the process of determining a business's worth. Investors use this valuation to get an idea of what the company they wish to buy is worth.

Depending on the method one chooses, a lot of data is required to value a business. For example, financial documents like the balance sheet or the cash flow statement are crucial.

Valuations, by nature, have some element of guesswork involved, although you must prepare some materials in advance. A founder should be prepared to evaluate their team's abilities and experience and pinpoint their strengths and weaknesses.

Valuations vary across sectors, regions, and periods. There are different approaches to determining the valuation of different types of startups, such as early-stage or pre-revenue firms.

Let's examine the various startup valuation techniques and the situations in which they work best. We will sort these methods into two groups - Pre-Revenue and Post-Revenue.

Pre-Revenue Valuation Methods

Pre-revenue means you haven't made any countable revenue from your product or service. Pre-revenue startups can be at varying stages in their startup lifecycle.

Even if you have just sketched out an idea or are on your way to putting your product in front of customers and everything in-between, your company is pre-revenue.

Pre-revenue status indicates that product research and development is advanced. For example, you may have an MVP (minimal viable product), a prototype that you are beta testing, and early adopters.

Raising funds is what you're doing to bring your product or service to the point where you can start charging for it. Pre-revenue capital typically aids in a company's product development or go-to-market strategy.

You can consider your valuation regarding how much equity you want to sell and how much you wish to raise before revenue. These pre-revenue ventures could also have a high valuation depending on their market.

1. Berkus Method

The Berkus Approach was developed by American angel investor and venture capitalist Dave Berkus. He was a well-known educator and has backed more than 80 startup businesses. 

The approach that angel investors have now adopted is also based on a book by Harvard professor Howard Stevenson which featured Dave's concept.

It considers valuing a startup business, particularly pre-revenue companies, based on a thorough analysis of five crucial success variables. These factors are:

1. Basic value
2. Technology
3. Execution
4. Strategic relationships in its core market
5. Production and consequent sales

The quantitative value of the five critical success elements to the enterprise's overall worth is assessed in depth. Then, these figures are used to value the startup.

Calculating revenue figures or comparing a product to competing items that appear comparable is not one of the main obstacles an early-stage firm seeks valuation encounters.

The straightforward approach protects founders and investors from making incorrect values based on anticipated revenues, which few startups achieve in the expected time frame.

The Stage Development Method or the Development Stage Valuation Approach are other names for the Berkus Approach.

This system limits pre-revenue values to $2 million and post-revenue valuations to $2.5 million. Although it doesn't consider additional market elements, the restricted scope is advantageous for firms searching for a straightforward tool.

2. Scorecard Method

Another choice for startups that have not yet generated income is the Scorecard Method, developed by angel investor Bill Payne.

This startup valuation method adjusts the average valuation of recently funded companies in the industry. It compares the target company to typical Angel-financed startup ventures to determine the target's pre-money value.

Founders can compare only companies in the same stage of development in this way. It also functions by contrasting your startup with others that have received funding but with additional requirements.

The first step is to determine the typical pre-money valuation of similar companies in the industry. Then, you have to check how worse or better your company is in the following characteristics:

• Strength of the management team and the skill set, flexibility, and experience of the founder(s) (0-30%) 
• The market size of the product or service the company offers, the strength of competition, and the expected time for increase (or generation) of revenues (0-25%)
• Product fit, Market definition, acceptance by the customers, and hindrances to entry (0-15%)
• Competitive environment: (0-10%)
• Marketing, sales channels, and partnerships: (0-10%)
• Need for additional investment: (0-5%)
• Other: (0-5%)

Then you will compare each attribute with your competitors and assign a comparison percentage to each quality depending on the following cases:

• On par - 100%,
• Below average - <100% or
• Above average - >100%.

For instance, you award your e-commerce team a 150% score because it consists entirely of skilled developers and marketers, some of whom have worked for competitors. Therefore, 30% would be multiplied by 150% to obtain a factor of.45.

By doing this, find the total components for each starting quality. Then, finally, to determine your pre-revenue valuation, double that amount by the typical valuation in your industry.

The value ratio is obtained by adding all the contributing components and multiplying it by the typical pre-revenue valuation of similar businesses. The resulting number provides the startup's value.

For instance, if a company received a factor of 1.07 and the average startup valuation is $2 million, investors would value the company at $2.14 million.

3. Risk Factor Summation Method

The Risk Factor Summation Approach evaluates a company by quantitatively accounting for all business risks that may impact return on investment. This way of valuing your startup is more comprehensive.

The risk factor summation method lets you determine whether your startup will succeed. You start by estimating the starting value using the other techniques covered in this article.

The impact of various business risks, whether positive or negative, is considered concerning this beginning value, and an estimate is subtracted from or added to the initial value based on the impact of the risk.

The monetary value can go up or down by multiples of $250,000, depending on the dangers your company is exposed to.

If it is a low-risk component, it will receive a double-plus grade (++), which will raise the valuation by $500,000. Conversely, for high-risk elements, the grade is a double-minus (--), and the valuation falls by $500,000.

For instance, you can rate your online bespoke apparel company favorably but only add $250,000 if there is a minor but minimal chance of competition.

A few of the most common risk categories are as follows: 

1. Management Risk
2. Manufacturing risk
3. Litigation risk
4. Technology risk
5. Competition risk
6. Political risk

The most challenging part of this strategy is deciding on an objective benchmark of comparison against which to measure each component.

4. Venture Capital (VC) Method

Bill Sahlman, a Harvard Business School Professor, first introduced the VC valuation method in 1987. Venture capital firms frequently use his approach to determine the value of a pre-revenue startup. 

This method is based on a simple equation:

Post-Money Valuation = Terminal Value ÷ Anticipated Return on Investment (ROI)

An appropriate ratio, such as the price-to-earnings ratio of the sector, is multiplied by a projected margin and expected revenue.

The company's terminal value is its expected selling price at some point in the future; for early-stage equities, the normal time frame is 5 to 8 years.

By determining a fair expectation for revenues in the year of sale and, based on those revenues, projecting earnings in the year of purchase, the value can be approximated.

Anticipated ROI: For this example, suppose that all investments must show the potential for returns of 10–40 times the investment (according to industry standards for early-stage investments).

Now that we have this knowledge, we can determine the pre-money valuation.

For example, a company with revenues of $2,000,000 upon exit might expect post-tax earnings of 15% or $300,000. Using available industry-specific price-to-earnings (PE) ratios, a 15x PE ratio for our company would give an estimated terminal value of $4.5 million.

Assuming our entrepreneur needs $50,000 to achieve positive cash flow and will grow organically after that, we'll need to calculate the pre-money valuation of this transaction in the following way:

Post-money valuation: $4.5m / 25x = $180,000

Pre-money valuation: $180,000 – $50,000 = $130,000

What if additional investment is required? By subtracting the projected dilution from later investors, it is simple to alter the pre-money valuation of the current round.

VC firms and other investors modify this and different strategies following their investment philosophies and procedures.

For instance, renowned VCs like Andreessen Horowitz utilizes the average revenue per user as a statistic (ARPU). VCs can consider the ARPU for related businesses when determining a pre-revenue company's valuation.

5. Cost to duplicate

The Cost-to-Duplicate Approach is fairly objective and is often considered a starting point for valuing startups. The key to this method is in the name.

It entails accounting for all costs and expenditures related to the business and the creation of its products, including the cost of buying the startup's physical assets.

By adding up a company's tangible assets' fair market worth, you can use this method to calculate the startup's value. The Investor may also add the costs associated with product development, research, and patents.

The cost-to-duplicate approach method examines a startup's assets and determines how much it would cost another person to start the same business elsewhere.

This method has a major flaw: it fails to consider the company's potential for future revenue generation, financial success, and return on investment.

It excludes the business's intangible assets, such as brand value, goodwill, or patent rights. Instead, it is argued that the company's intangibles may still have a lot to offer for its price even at this early stage.

Inherently, this approach falls short of capturing a company's entire value, especially if it is making money. Additionally, it's frequently employed as a "lowball" assessment of firm value because it typically undervalues the venture's value.

Post-Revenue Valuation Methods

Post-revenue businesses are the ones that have begun to generate sales. Their sales and marketing processes are finely tuned, generating consistent and growing revenues. These ventures may or may not be profitable.

Post-revenue valuation methods are best used when a business is generating sales but hasn't yet hit positive cash flow—post-revenue valuation methods depending on where the company currently resides with respect to its revenue and profits.

These ventures usually need funding to expand and scale their already existing operation. These methods can give investors and entrepreneurs an idea of what the business is worth.

Valuing post-revenue companies is complex and can sometimes be subjective. It requires guesstimating the probability of success of the venture and then calculating a value based on a financial model and competitive analysis. There are several ways of doing that.

1. Discounted Cash Flow Method (DCF)

The Discounted Cash Flow (DCF) Method projects the startup's future cash flow movements. The help of a market analyst or an investor is advised when using this technique.

The first step is determining the anticipated future cash flows or the anticipated rate of return on investment (ROI). Then you add a forecasted "discount rate" to them. This will give you the amount of the investment's return.

The riskier the investment and the better your growth rate, the higher the discount rate. This rate is calculated based on the subject's lifecycle stage. A high discount rate is typically used for startups in their early stages, and investing in them carries significant risk.

It might be difficult to predict the future cash flows of young enterprises. Since many companies attempt to expand as quickly as possible, their cash flow could be small or nonexistent.

Moreover, any financial forecast is tough due to a lack of economic data and activities geared toward growth.

By creating a valuation in this manner, the entrepreneur can better engage investors in meaningful valuation discussions and direct them toward the basic assumptions that underpin value.

The quality of the valuation depends on how well the analyst can predict future market conditions. Forecasting profitability and sales more than a few years in the future can frequently become as good as an educated guess.

The value that DCF models provide is also impacted by the estimated rate of return employed for discounting cash flows. As a result, it must be handled carefully.

2. Comparable Transactions Method (Comps Method)

The Comparable Transactions Method is one of the most popular startup valuation techniques because it's based on precedent. 

The comparable transactions technique determines a company's value by analyzing how much similar firms were recently acquired for, using this data as a benchmark.

This approach might be most effective when contrasting two startups that produce equivalent goods or provide comparable services.

Consider the following scenario; a fictitious startup is purchased for $25 million. 500,000 people used its website and mobile app. The cost per user is $50. As a result, 100,000 people utilize your startup. This results in a $5 million valuation for your company.

Revenue multiples for similar businesses in your industry are also available. For example, companies making 5 to 7 times their net income from the prior year may be typical in your industry.

Any comparison model should consider ratios or multipliers for any significant differences between the two businesses.

For instance, you might wish to employ a multiplier at the lower end of the range, such as 5x (or lower) in the example above, if another company has proprietary technology but you do not.

You can establish a suitable value range by examining these comparable deals. This valuation method's drawback is that a startup's valuation might significantly fluctuate depending on the state of the market.

The disadvantage of this technique is that depending on the state of the market; the valuation can fluctuate. One should consider deciding which valuation approach is best for the business.

The valuation also depends on investor trends in the market. For example, a Fintech company may be more popular compared to an Edtech company. This more general issue is present in all financial markets and is not specific to startups.

The Market Multiples Approach and this approach are comparable. Using multiple ratios derived by dividing one financial indicator by another of similar private enterprises, a multiple analysis extrapolates the worth of a company.

Imagine that the proprietors of a mobile gaming company with $10 million in annual revenue want to set their company's price. According to research, some rivals have lately been bought out for 5x revenue. So then, business owners can choose to price their firm at $50 million.

3. First Chicago Method

The First Chicago technique generates a prognosis for the company that could have several results. Since it employs terminal values and cash flows, this method combines the DCF and Comps methods.

This approach is perfect for a business with rapid expansion. Post-money valuation is the main concern in this approach. An investor may be able to see the potential for business growth using this strategy.

A startup in its early stages lacks previous data to project future growth. Because of this, there is a strong likelihood that the expected and substantial growth will differ.

The greatest method for predicting a startup's future growth is to consider every situation, including the best, most likely, and worst-case scenarios.

The present value of each outcome is determined as the first step in each of these scenarios. The likelihood of the result is also important. The total of all appraisals multiplied by each probability would represent the final valuation.

For instance, let’s assume three scenarios for a particular startup.

• Best case= $25M, 15% chance 
• Average= $10M, 65% chance
• Worst case= $3M, 20% chance

Final Valuation= 0.15*25 + 0.65*10 + 0.2*3 = $10.85

Conclusion

There are various methods of valuing a startup. Choosing a particular method or a set of methods depends on multiple factors, including the stage of the startup and who is valuing the startup. 

A company's valuation is uncertain at an earlier stage because it may or may not succeed. While for a revenue-making venture, it is comparatively easier.

A founder's justifiable valuation is important so potential investors can trust them. But no method gives a precise valuation. So you are better off choosing a pair or more of these methods in many cases.

There are plenty of other methods as well, but there are only slight differences between them. Almost all of the plans have a human and monetary element to them.

No method could give you consistent and accurate valuations. You will have to combine several methods to get a fair value.

Once you decide which method or methods to choose, the valuation thus obtained can be very helpful to investors and the founders.

Researched and authored by Chinmay Bohra | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Assessed Value
• Ballpark Figure
• Beta
• Discounted Cash Flow
• Leveraged Buyout (LBO)