Startup valuation is both art and science combined. The gut, instinct, and gut instincts are usually involved. Well established companies are easier to value because you can throw their revenue in a spreadsheet and work its magic. They have numbers. A startup in its initial state lacks solid numbers. Only forecasted values are available, and those are just an estimation.
Why is valuing a startup necessary, you might ask. Valuing helps an investor decide if the startup is worth investing in. And why are startups valued so high? Showing a high and solid valuation attracts investors like bees to honey. The valuation also helps entrepreneurs in determining how much of a share to give to investors in exchange for their money.
But having a high valuation at the start is not compulsory. It just means that a high valuation at the seed round implies higher valuation in the next round. For that, you will need to show considerable growth. A general metric is showing 10x growth over eighteen months. There are two strategies regarding valuations:
- Go big or go home – Raise a large amount at the highest valuation and grow as fast as possible. If successful, the seed round will fund itself. And the dilution rate is less as compared to a slow-growing startup.
- Slow and steady – This involves a steady growth rate where you raise only as much as you need and spend as little as possible.
Factors That Impact Startup Valuation
If the industry is booming, investors are more likely to sink money into your venture.
Showing that your company has customers is a surefire way of showing high valuation.
If the owner has a stellar record of running businesses or the product/service is a successful one, investors are more likely to get attracted even if the business lacks a customer base.
Supply & Demand
If the demand is high, a high valuation can be placed. If the supply is higher than demand, investors might be less willing to invest a large amount.
Lack of need for the product or if the product is not of good value, the valuation of the business is lowered.
The business will find it difficult to carve a niche for itself if there is no scope left, i.e if there is heavy competition.
Sometimes, an outstanding team is enough to inspire confidence in an investor. Lacking that can make things go downhill.
This depends on whether you already have a commercial product/service in hand and if it is generating any revenue. An existing revenue is a positive cause for convincing an investor.
Methods of Valuation of Startups
In this method, the hard assets are taken into account and the cost of duplicating the same business elsewhere is estimated. Unfortunately, this method does not take into consideration the growth potential and intangible assets such as brand value, industry trends, or reputation. This method gives us the ‘lowball’ estimate of the venture.
Discounted Cash Flow
This method determines the cash flows generated in the future and sets and applies a discount rate to the value to arrive at the probable valuation. The cash flow determination depends on market fluctuations and the ability of the analyst to make good assumptions. The discount rate is proportional to the risk factor.
This is the most popular method in use. It is used for the valuation of pre-revenue startups. This is how it works :
|If It Exists||Add Company Value Upto|
|A Sound idea||$ 0.5 million|
|Prototype or working model||$ 0.5 million|
|Quality management team/ Reputed leader||$ 0.5 million|
|Strategic relationships/ Partnerships with industry||$ 0.5 million|
|Product rollout or sales (initial revenue)||$ 0.5 million|
Table source: https://berkonomics.com/?p=1214
This method works on the principle ‘one price for all’, meaning similar companies are worth the same. Essentially, similar startups are compared. It uses industry ratios such as price-to-earnings ratio, price-to-sales ratio, values-to-earning before interest, etc., It also takes factors that are not similar for both companies into account.
Image Source: CFI
One disadvantage of this method is that there is a slim chance of finding similar startups as business ideas tend to be unique.
Scorecard Valuation Method
The average pre-money valuation of all startup businesses in the area is determined. The startup in question is valued against them on the basis of a scorecard. The Scorecard consists of the following factors and their weightage.
Risk Factor Summation Method
This method uses the same average pre-money valuation method and compares twelve elements of a target startup to a funded and profitable startup. The elements are as follows:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each parameter is awarded a value ranging from +2 to -2, with +2 being a positive valuation of the company for that parameter and -2 being negative.
Valuation By Stage Method
This method is similar to the Berkus method but treats the parameters in the latter as subsequent stages. Generally, the stages appear to be:
- ‘An exciting business plan’ -may warrant around half a million
- ‘A strong management team’ - may warrant one million
- ‘Availability of prototype or finished product’- may warrant around 1-2 million
- ‘Partnerships or steady customer base’- may warrant around 2-5 million
- ‘Shows signs of growth and profitability’- may warrant greater than 5 million
The amount is the valuation of the company and gives an idea of how much an investor might be willing to invest in your startup.
Venture Capital Method
Professor Bill Sahlman of Harvard business school introduced this method. The following formulae are used:
- Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
- Post-money Valuation = Terminal Value ÷ Anticipated ROI
This method is meant for pre- as well as post-revenue startups.
First Chicago Method
This method is a very qualitative way of determining the state of the startup. Three different evaluations are given based on the best-case scenario, the worst-case scenario, and the normal scenario.
Book Value Method
This method is used when the startup faces a loss and is going out of business. The valuation is done considering only the tangible assets of the company. Growth, revenue, branding, etc., do not matter.
Any method on its own is not sufficient to get a correct estimate. The best approach would be to evaluate the startup using multiple methods. Those methods on average will give us an approximately accurate guesstimate. Not to mention some methods are merely qualitative. Valuations are handy when you turn to fundraising.
There is no hard and fast rule when it comes to scoring funding. Sometimes, the person, the brand, or the team might convince the investor rather than the calculated numbers. It is a matter of skillful negotiation and instilling faith in the investor that your company deserves the funding.