Startup Valuation Methods: Everything You Need to Know
What Are Startup Valuation Methods?
Startup valuation methods are the ways in which a startup business owner can work out the value of their company. These methods are important because more often than not startups are at a pre-revenue stage in their life-span so there aren't any hard facts or revenue figures to base the value of the business on.
Because of this guesswork, an estimation has to be used, which is why several startup valuation method frameworks have been invented to help a startup business more accurately guess their valuation.
Business owners want the value to be as high as possible, whilst investors want the value to be low enough that they'll see a big return on their investment.
What Is a Startup
A startup company is a new business that is potentially fast-growing and aims to fill a hole in the marketplace by developing and offering a new and unique product, process, or service but is still overcoming problems.
Startup companies need to receive various types of funding in order to rapidly develop a business from their initial business model that they can grow and build up.
Difference Between Startup Valuation and Mature Business Valuation
Startup businesses will usually have little or no revenue or profits and are still in a stage of instability. It is likely their product, procedure, or service has reached the market yet. Because of this, it can be difficult to place a valuation on the company.
With mature publicly listed businesses that receive steady revenue and earnings, it is a lot easier. All you have to do is value the company as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA).
EBITDA is best shown with the following formula - EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization
For example, if a company earns $1,000,000 in revenue and production costs of $400,000 with $200,000 in operating expenses, as well as a depreciation and amortization expense of $100,000 that leaves an operating profit of $300,000. The interest expense is $50,000 leading to earnings before taxes of $250,000. With a 20 percent tax-rate, the net income becomes $200,000. With EBITDA you would add the $200,000 net profit to the tax and interest to get the operating income of $300,000 and add on the depreciation and amortization expense of $100,000 giving you a company valuation of $400,000.
With startup valuations, there is no substantial information to base a valuation on other than assumptions and educated guesses.
What determines a startup value?
Traction – One of the biggest factors of proving a valuation is to show that your company has customers. If you have 100,000 customers you have a good shot at raising $1 million.
Reputation – If a startup owner has a track record of coming up with good ideas or running successful businesses, or the product, procedure or service already has a good reputation a startup is more likely to get a higher valuation, even if there isn't traction.
Prototype – Any prototype that a business may have that displays the product/service will help.
Revenues – More important to a business to business startups rather than consumer startups but revenue streams like charging users will make a company easier to value.
Supply and Demand – If there are more business owners seeking money than investors willing to invest, this could affect your business valuation. This also includes a business owner's desperation to secure an investment, and an investors willingness to pay a premium.
Distribution Channel – Where a startup sells its product is important if you get a good distribution channel the value of a startup will be more likely to be higher.
Hotness of Industry – If a particular industry is booming or popular (like mobile gaming) investors are more likely to pay a premium, meaning your startup will be worth more if it falls in the right industry.
Poor Industry – If a startup is in an industry that has recently shown poor performance, or maybe dying off.
Low Margins – Some startups will be in industries or sell products that have low-margins, making an investment less desirable.
Competition – Some industry sectors have a lot of competition or other business that has cornered the market. A startup that might be competing in this situation is likely to put off investors.
Management Not Up To Scratch – If the management team of a startup has no track record or reputation, or key positions are missing.
Product – If the product doesn't work, or has no traction and doesn't seem to be popular or a good idea.
Desperation – If the business owner is seeking investment because they are close to running out of cash.
Because startups typically go through a series of 'funding stages' their valuations can differ after each round of funding, and typically they'll want to show growth between each round, the usual funding stages are as follows,
Seed Funding – Typically known as the 'friends and family' round because it's usually people known to the business owner who provide the initial investment. But, Seed funding can also come from someone not known to the founder called an 'Angel Investor'. Seed Capital is often given in exchange for a percentage of the equity of the business, usually 20% or less, with funds raised usually between $250,000 and $2,000,000.
Round A Funding – This is the stage that venture capital firms usually get involved. It is when startups have a strong idea about their business and product and may have even launched it commercially. The Round A funding is typically used to establish a product in the market and take the business to the next level or to make up the shortfall of the startup not yet being profitable. Funds raised usually fall between $2 and $15 million.
Round B Funding – The startup has established itself but needs to expand, either with staff growth, new markets or acquisitions.
Debt Funding – When a startup is fully established it can raise money through a loan or debt that it will pay back, such as venture debt, or lines of credit from a bank.
Mezzanine Financing and Bridge Loans – Typically the last round of funding where extra funds are acquired in bridge financing loans in the run-up to an IPO, acquisition, management buyout, or leveraged buyout. This is usually short-term debt with the proceeds of the IPO or buyout paying it back.
Leveraged Buyout (LBO) – A Leveraged Buyout is the purchase of a company with a significant amount of borrowed money in the form of bonds or loans instead of cash. Usually, the assets of the business being purchased are used as leverage and collateral for the loan used to purchase it.
Initial Public Offering (IPO) – An Initial Public Offering is when the shares of a company are sold on a public stock exchange where anyone can invest in the business. IPO opening stock prices are usually set with the help of investment bankers who help sell the shares.
Why are Startup Valuation Methods Important?
When an early-stage investor is trying to decide if they should make an investment into a startup he will guess what the likely exit size will be for that startup of a type, and in a specific industry. If a business owner has used methods to show their startup is worth a high amount that investor is likely to invest more into the company.
Using these methods or frameworks is also important because startup companies lack the reliable past performance and predictable future performance that most established businesses use to estimate their value so having a way to guess a valuation is useful, even if it is all guesswork and predictions.
Ideally, a business owner should use several startup valuation methods to get the most accurate valuation possible. A business owner will want all of the valuations they come to form each of the methods to be within a sensible average. For example, a startup trying to secure 'seed' investment will offer 10 percent of the company for $100,000. This values the company at $1,000,000 but that doesn't necessarily mean it is actually worth $1,000,000 but the startup is suggesting to the investor that there is a potential for the company to be worth that figure after growth and investment.
Things to Consider When Choosing a Startup Valuation Method
Knowledge of other businesses in an industry and geographical location and what they are valued at is key to figuring out the value of a startup in the same industry and location, which is why several of the startup valuation methods include this.
A business owner should not stop with one approach. Angel investors and business owners will want to use several methods because no single method is useful all of the time. Multiple methods also help a startup determine an average valuation.
Finding this average valuation is important because none of the startup valuation methods is scientifically or mathematically accurate, they are all based on predictions and guesswork.
The Most Popular Startup Valuation Methods
There are many different methods used in deciding on a startup's valuation, while all of them differ in some way, they are all good to use.
Venture Capital Method
Scorecard Valuation Method
Risk Factor Summation Method
Discounted Cash Flow Method
Valuation By Stage Method
The Book Value Method
First Chicago Method
Venture Capital Method
The Venture Capital Method (VC Method) is one of the methods for showing the pre-money valuation of pre-revenue startups. The concept was first described by Professor Bill Sahlman at Harvard Business School in 1987.
It uses the following formulas:
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
Post-money Valuation = Terminal Value ÷ Anticipated ROI
Terminal (or Harvest) value is the startup's anticipated selling price in the future, estimated by using reasonable expectation for revenues in the year of sale and estimating earnings.
If we have a tech business with a terminal value of 4,000,000 with an anticipated return of investment of 20X and they need $100,000 to get a positive cash flow we can do the following calculations.
Post-money Valuation = Terminal Value ÷ Anticipated ROI = $4 million ÷ 20XPost-money Valuation = $200,000Pre-money Valuation = Post-money Valuation – Investment = $200,000 - $100,000Pre-money Valuation = $100,000
The Berkus Method assigns a range of values to the progress startup business owners have made in their attempts to get the startup off of the ground. The following table is the up to date Berkus Method:
Scorecard Valuation Method
The Scorecard Valuation Method uses the average pre-money valuation of other seed/startup businesses in the area and then judges the startup that needs valuing against them using a scorecard in order to get an accurate valuation
The first step is to find out the average pre-money valuation of pre-revenue companies in the region and business sector of the target startup
The next step is to find out the pre-money valuation of pre-revenue companies using the Scorecard Method to compare. The scorecard is as follows,
Strength of the Management Team – 0-30 percent
Size of the Opportunity – 0-25 percent
Product/Technology – 0-15 percent
Competitive Environment – 0-10 percent
Marketing/Sales Channels/Partnerships – 0-10 percent
Need For Additional Investment – 0-5 percent
Other – 0-5 percent
The final step is to assign a factor to each of the above qualities based on the target startup and then to multiply the sum of factors by the average pre-money valuation of pre-revenue companies
For more information on the scorecard method, please visit here
Risk Factor Summation Method
The Risk Factor Summation Method compares 12 elements of the target startup to what could be expected in a fundable and possibly profitable seed/startup using the same average pre-money valuation of pre-revenue startups in the area as the Scorecard method. The 12 elements are,
Stage of the business
Sales and marketing risk
Funding/capital raising risk
Potential lucrative exit
Each element is assessed as follows:
+2 - very positive for growing the company and executing a wonderful exit
+1 - positive
0 - neutral
-1 - negative for growing the company and executing a wonderful exit
-2 - very negative
The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2).
This approach involves looking at the hard assets of a startup and working out how much it would cost to replicate the same startup business somewhere else. The idea is that an investor wouldn't invest more than it would cost to duplicate the business.
For example, if you wanted to find the cost-to-duplicate a software business, you would look at the labour cost for programmers and the amount of programming time that has been used to design the software.
The big problem with this method is that it doesn't include the future potential of the startup or intangible assets like brand value, reputation or hotness of the market.
With this is in mind, the cash-to-duplicate method is often used as a 'lowball' estimate of company value
Discounted Cash Flow (DCF) Method
This method involves predicting how much cash flow the company will produce, and then calculating how much that cash flow is worth against an expected rate of investment return. A higher discount rate is then applied to startups to show the high risk that the company will fail as it's just starting out.
This method relies on a market analyst's ability to make good assumptions about long term growth which for many startups becomes a guessing game after a couple of years.
Valuation by Stage
The valuation by stage method is often used by angel investors and venture capital firms to come up with a quick range of startup valuation.
This method uses the various stages of funding to decide how much risk is still present with investing in a startup. The further along a business is along the stages of funding the less the present risk. A valuation-by-stage model might look something like this:
Estimated Company Value Stage of Development $250,000 - $500,000
Has an exciting business idea or business plan $500,000 - $1 million
Has a strong management team in place to execute on the plan $1 million – $2 million
Has a final product or technology prototype $2 million – $5 million
Has strategic alliances or partners, or signs of a customer base $5 million and up
Startups with just a business plan will receive a small valuation, but that will increase as they meet developmental milestones.
This method is to literally look at the implied valuations of other similar startups, factoring in other ratios and multipliers for things that may not be similar between the two businesses.
For example, if Startup A is acquired for $7,500,000, and its website had 250,000 active users, you can estimate a valuation between the price of the startup and the number of users, which is $30/user.
Startup B might have 125,000 users which would then allow it to use the same multiple of $30/user to reach a valuation of $3,750,000
The Book Value Method
This method is based solely on the net worth of the company. i.e. the tangible assets of the company. This doesn't take into account any form of growth or revenue and is usually only applied when a startup is going out of business.
First Chicago Method
This method factors in the possibility of a startup really taking off, or really going badly. To do this it gives a business owner three different valuations
Worst case scenario
Normal case scenario
Best case scenario
Do I Need To Use Startup Valuation Methods?
Whilst it is helpful to have a valuation of a startup in order to help investors offer the right amount of money needed it isn't necessarily the dominant reason why an investor will invest in a startup.
Quite often convincing an investor that a startup has value is more about negotiating, convincing and being passionate and bold about the business idea. Whilst there's no concrete evidence of a startup valuation there is evidence that you, as a business owner will do everything you can to make the business work.
As a result, investors will sometimes invest in people rather than the business idea
Do Startups Need A High Valuation To Be Successful?
The success of a startup doesn't rely on it receiving a high valuation, and in some cases, it is better to not receive a high valuation. When you get a high valuation for your seed round, you need a higher one for the next funding round, meaning that a lot of growth is needed between rounds.
A good general rule to follow is that within 18 months a startup will need to show that it grew ten times. This is usually achieved with one of the two following strategies.
Go big or go home – A startup can raise as much money as possible at the highest valuation possible, spending that money to encourage as much growth as possible as quickly as possible. If successful a startup will have a much bigger valuation in the next funding round and often, the 'Seed' round will pay for itself.
Pay as you go – a startup would only raise money that it needs, spending as little as possible whilst aiming for steady growth
Assuming a value is permanent or always right
When it comes down to it, a startup is worth what an investor is willing to invest. A startup business owner might disagree with an investor's valuation because their own valuation is different.
But as these valuations are based on predictions a startup owner should not assume that the value is permanent or right.
Assuming a value is straightforward
Business valuation is never straightforward for any company. It is constantly changing and there are so many factors. For a startup, this is even truer because there's nothing to go on.
It is best to discuss this with the potential investor so that the business owner and the investor agree, especially as this figure will go on to decide the startup's valuation.