Business valuation is never straightforward and there is no “one size fits all” method. It is the analytical process of determining the current (or projected) worth of an asset or a company. There are many methods used for doing a valuation and this applies the same to startup valuation. In fact, it can be quite a tricky endeavour to perform startup valuation.
There are many factors to take into consideration like the management team, product demand, market trends and marketing risks involved. Here’s the bomb: even after evaluating everything with the most effective valuation formula, the best you can hope for is still an estimate.
Startup valuation methods are particularly important because they are applied to startup companies that are currently at pre-revenue stage and business owners will hope for a high valuation whereas investors will prefer a lower value that promises a higher return on investment (ROI). Unlike mature businesses, there are no financial records or steady stream of revenues to ease calculations of the startup valuation.
Venture capital firms and individual investors have dozens of methods to perform startup valuation with a range of easy and complex ones that involve several qualitative and quantitative variables.
These are 6 commonly used methods:
1. Venture Capital Method
This is a start up valuation that deploys a forecasted terminal value for the startup and an expected return from the investor, often stated as 10X, 8X and so on. It is to determine the pre-money and post-money valuations. The formula is as follows:
Pre-Money Valuation = Post-Money Valuation – Invested Capital
With the Post-Money Valuation being the terminal value divided between the expected return.
Eg. An investor values your startup at a terminal value of $2,000,000 and he wants a 20X return on his $20,000 investment so it will be $2,000,000 divided by 20X and that will give you $100,000 for the Post-Money valuation.
For Pre-Money Valuation, it will be $100,000 – $20,000 = $80,000
2. Cost To Duplicate Method
This method requires some due diligence as its main purpose is to determine how much it would cost to start the business from scratch. It is a very realistic approach that questions the competitive advantages of a startup.
If the cost of duplicating the startup is very low, then its value will be worth almost nothing. However, if it is costly and complex to replicate the startup business model, then the startup valuation will increase proportionately with the cost and complexity.
3. Berkus Method
A straightforward method that values startups based on five key aspects and giving each aspect a certain amount of money. The five qualitative aspects are sound idea, prototype, high quality management team, strategic relationships and product rollout or sales made $500,000 each.
For each aspect the startup possesses in full, the valuation should go up by $500,000. However, it depends on the extent in which each aspect is developed. The investor could possibly reduce the value of the item to $300,000 or $150,000, to determine the final value.
4. Discounted Cash Flow Method
This is a technical tool employed by financial analysts to determine the value of a business by estimating its future cash flows and discounting them at a certain discount rate to obtain their present value.
The sum of the discounted cash flows will be the determined amount for the startup valuation and given the fact that this method relies on assumptions with the performance of some historical data, it is not the most popular method used to do startup valuation.
5. Comparables Method
This method uses referential information and numbers from similar transactions to estimate the value of a startup. Eg. A similar app to the one developed by the startup was recently valued by a venture capital firm at $3,000,000 and the app had 100,000 active users.
This means that the company was valued at $30 per user. An investor could use this as a benchmark to value a startup with a similar app. The comparables method provides an observable value for the startup hence it is the most widely used approach as it is easy to calculate and always current.
6. Valuation By Multiples Method
This is usually used on startups that have already made some money and are showing profits. Eg. The startup is generating an EBITDA of $300,000. Depending on the industry the startup is in, competition, management team and some other qualitative aspects, an investor could tell you he is valuing your business at 5X, 10X or 15X the current EBITDA.
The EBITDA margins provide investors with a snapshot of the startup’s short term operational efficiency. As the margins ignore the impacts of non-operating factors such as taxes or intangible assets, the result is a more accurate reflection of the startup’s operating profitability hence this method is used by investors to quickly estimate the value of a more mature startup.
There are more methods but these are some of the most commonly used for startup valuation. There is no perfect method to value a business that is at the pre-revenue stage but it gives you an idea of what you could expect and ask for your startup. We hope this puts you in a better position when it comes to the funding stages.