Understanding The Common Startup Valuation Methods

Both investors and young entrepreneurs need to understand how to value startups.  Startup valuation is critical for businesses that are at a pre-revenue phase. It determines how much revenue it will generate for the investor while cementing the startup in the pages of history in contrast to reducing the entrepreneur and startup as nothing more than a footnote in history. Both entrepreneurs and investors need to know how to calculate the valuation of a startup.

Without a proper valuation figure, entrepreneurs will find it impossible to pitch their new business to any investors. Conversely, investors need to know the correct valuation of a startup to invest appropriately to gain any return on investment from the company.

Startup valuation is a complex issue to analyze and quantify. Unlike a traditional company, there is no history of past financial performance to go by to value a startup. Revenue for a startup may be non-existent or minimal, and the company may have no assets to create a fixed valuation. New startups are also not listed on any stock exchange, so investors cannot look at the stock market capitalization figure to gauge the value of a company.

All these differences ensure that a startup cannot be valued using the same metrics to value a fully-fledged and running business. The valuation of a startup is thus significantly more difficult to gauge than any other kind of company.

 

Let’s take a look at some methods of startup valuation.

 

 

The most common method of startup valuation is The Berkus Method. The technique was developed in the 1990s by a venture capitalist called Dave Berkus and quickly gained popularity when it was published in the famous book “Winning Angels” by Harvard’s Amis and Stevenson in 2001.

This method focuses on trying to find an accurate pre-revenue valuation of a startup. The method works by placing a quantitative term, a financial valuation, to the five significant elements of risk faced by new companies.

These five major elements are the basic idea of the startup, prototype, quality management team, strategic relationships, product rollout, and sales.

Each segment under this is given a maximum valuation of up to half a million dollars to account for the significant risk in investing in a pre-revenue company. This value can be reduced based on risk assumed from any of these segments but puts a maximum valuation of any such company at 2.5 million dollars.

 

If it exists	Add to company value up to
Basic idea	$0.5 million
Prototype	$0.5 million
quality management team	$0.5 million
strategic relationships	$0.5 million
product rollout and sales	$0.5 million

 

 

 

A common startup valuation method is the Cost-to-Duplicate Approach. This process focuses on taking into account all the costs associated with the business and the cost of the development of the product. The final amount generated is the same amount it would take for anyone to duplicate the startup at the time of valuation. Physical assets are also part of this evaluation. This method helps paint a clear picture of what the valuation of a company is based on what unique factor a startup brings to the marketplace.

The model is accurate in predicting a realistic valuation as it takes into account everything from labor to research and development. This method of startup valuation, however, fails to account for the future sales of a company. It also prioritizes specialized startups that may be difficult to replicate over basic new companies whose products, development, and business processes may be easily copied.

 

 

 

The Discounted Cash Flow Method is a process of startup valuation that focuses on creating a prediction of future cash flow in the business. It requires extensive market and business analysis and may even mandate the use of an external business analyst. The method constructs a discount rate based on the fact that money in the future is inherently worth less than money in the present.

Taking this into account, DCF creates a present value for the future cash generated by the business. If the value generated by DCF is higher than the current cost of investing in the startup, it is a profitable investment. It is vital for the success of this method that the prediction of future cash flow is accurate.

The discount rate must also be set. The higher the discount rate, the lower the DCF. To calculate the present value of future cash flow, analysts use the following equation.

 

Source: Investopedia.com

There are, however, some risks with this process, as many assumptions must be made about future cash flow and the discount rate. This process may not work for complex startups, as any miscalculation or missed data point can lead to a disastrously wrong evaluation.

 

 

 

This method of startup valuation focuses on the risks attached to investing in a new startup. A quantitative figure is given to all the dangers connected with investing in the business, and that affects the return on investment. First, an initial valuation is reached using any method, then risk factor summation is applied to get a more accurate picture. For any element that is deemed not risky, it is given a (++) ranking, and half a million dollars is added to the valuation. Conversely, for any risky element, a (–) is given, and half a million dollars is subtracted from the overall evaluation. A single + or – leads to changes in a quarter of a  million dollars. Some common elements include Management, Stage of the business, Legislative or Political risk, Manufacturing risk, Sales and marketing risk, Funding/capital raising risk, and Competition risk.

While this method allows a significant amount of flexibility over the final valuation, it is not easy to determine which initial evaluation to start with. Additionally, it is difficult to measure the objective chance of success or risk of any individual element.

 

 

 

The market multiple approach is used mostly by venture capitalist firms. The model is based on the idea that similar assets are worth an equal amount of money. Towards this end, the market multiple approaches seek to use companies that are comparable to the startup to calculate a valuation. The approach aims to capture the similarities between different startups or firms, such as expected growth, research and development cost, cost of prototyping, etc.

The first step is to identify similar companies and evaluating their market size and capitalization. A financial value is then calculated from compounding the figures generated and then is applied to the firm. This figure is called the base market multiple and determines the value of the new acquisition.

This process is one of the most popular evaluation methods in recent years as it gives a reasonable estimation of the valuation of a company while taking into account the context of the region, geography, and the economy, as all those factors affect other similar businesses as well. Rough estimates from similar companies give a good understanding of how to estimate the valuation of a startup.

 

 

 

This method is similar to the market multiple approach because they both use context to help generate the final value. Instead of using the whole company or various companies as an example to set the base price, however, individual transactions of similar companies are used to come to a final evaluation.

If a similar company generates $2 million and has 200,000 users, that leads to a value of 10$ per user. If an entrepreneur’s startup has 100,000 users, that leads to a startup valuation of $1 million. Comparable to the market multiplier approach, a multiplier can be added to adjust the per-user price based on factors such as if the company has proprietary technology or not.

See Also: 12 Ways To Raise Money For a Startup

 

 

These techniques are helpful for both entrepreneurs and investors to know how to commit to a successful startup valuation. This process is simply the first step towards developing a startup that can be operational and successful. While none of these estimates are perfect, they can explain where the company lies and how to make it successful in the future.

 

 

---