It’s exceedingly difficult to accurately determine a company’s value while it’s still in its infancy. That’s because its ultimate failure or success remains unknown.
However, hard as it might be, you’re going to need to do a valuation on your company so you know how much it’s worth in the marketplace. In this article, we’ll go over five startup valuation methods.
The 5 best startup valuation methods
Business valuation is never easy. For startups with little or no revenue, the task of valuing the enterprise becomes especially challenging. You usually value mature companies with steady revenues as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA).
It’s infinitely harder to value a new startup that isn't publicly listed and has no sales figures yet. Still, if you are trying to raise capital for your startup, it's crucial to determine your company's worth.
Some approaches—like discounted cash flows—can be used to value both startups and established ventures. There are some other valuation methods only used with startup companies.
This method asks the question, "What would it cost to build another company just like mine from scratch?" The cost-to-duplicate approach is predicated on the premise that nobody would pay more for a company than it would cost to replicate it.
This method considers the fair market valuation of your startup’s physical assets. It also figures in research and development, patent, and prototype building expenses.
One big problem with this method is that it completely ignores your organization’s future potential for generating sales, profits, and return on investment. Another problem is that it doesn’t account for intangible assets like brand recognition.
Your company's physical infrastructure might be only a tiny component of your enterprise's net worth. The danger is that you could end up seriously underestimating your venture's value because only the tangible assets of a company are used in a valuation.
Valuation methods that depend on real-world earnings can't be used to value startups because there's not enough money trickling in yet. That's why market multiples can be a popular valuation method for companies in their infancy.
When you use the market multiples method, you'll value your startup against recent acquisitions of similar enterprises in the market. Venture capitalists love this approach because it provides them with an excellent indication of what the market is willing to shell out for a company.
For example, let's say you have an e-commerce startup you want to do a valuation on. You do a little market research and discover that companies like yours are selling for four times their annual gross revenue.
Knowing what investors are willing to pay for similar e-commerce companies, you use a “four times” multiple as the basis for valuing your business.
However, you might want to tinker with these numbers a bit to account for circumstances unique to your company. For instance, if your company was further along in the development process than most, you would increase the multiple to five.
The problem with this method is comparable market transactions can be difficult to track down because many early-stage enterprises keep their deal terms under wraps.
Discounted cash flow (DCF)
The beauty of the DCF method is that it values an enterprise not on its current performance but on future potential. This makes this method perfect for startups.
The DCF method forecasts how much cash flow your business will produce in later years. It does that by using an expected investment return rate to calculate how much the cash flow is worth.
You start an innovative car manufacturing company that uses hydrogen as fuel. Suppose you're able to transform that enterprise from a struggling business into a thriving corporation. In that case, it's safe to say your startup has massive future potential.
That’s why it makes sense that the current value of your business should include future profits. A DCF valuation takes this into account. However, the value of these future earnings is worth less today than it will be in the future. This has to do with the time value of money.
If I gave you $1,000, you could invest that cash in the stock market. In one year, you could watch as your initial investment mushrooms into $1,100. Because this is a 10% rate of return, the $1,000 I promised to give you in the future is only worth $900 now.
When you use the DCF method, you’re going to need to discount the value of future earnings to how much they would be worth today. That’s because there’s always a risk that future revenue streams will never be realized.
Here’s a formula you can use to do your DCF valuation.
The problem with the DCF method is that it depends on an analyst's ability to accurately predict future market conditions. The analyst then must make reasonable assumptions about long-term growth rates.
Valuation by stage (Berkus approach)
Startup valuations must be low enough to allow for the extreme risk taken by investors. The Berkus Method, named after its creator Dave Berkus, does an excellent job doing that.
Of course, the problem with early-stage enterprise valuation is the lack of hard numbers. Even if these figures are available, only a few startups live up to their initial financial projections. This is the main reason why purely quantitative valuation models don’t often lead to accurate results.
The Berkus approach avoids this problem by adding a qualitative dimension to quantitative analysis. A detailed assessment is carried out evaluating how much value the five critical success factors add to the enterprise's total value.
You assign a value to the startup based on these numbers. The Berkus Approach may also be referred to as "the Stage Development Method or the Development Stage Valuation Approach."
The method is based on five elements:
- 250,000 - $500,000: The company has an exciting business idea
- $500,000 - $1 million: The company has assembled an excellent management team
- $1 million – $2 million: The company has a solid product or prototype that'll make customers swoon
- $2 million – $5 million: The company has powerful strategic alliances, partners, or a burgeoning customer base
- $5 million and up: The company has signs of revenue growth and a pathway to profitability
The further the company has progressed in its evolution, the lower its risk and the higher its value. Angel investors often use this method to come up with a ballpark figure of company value.
The value ranges will vary, depending on the company and the investor. Startups with nothing more than a business plan will likely get the lowest valuations. As the company succeeds in reaching milestones, investors will be willing to assign a higher value.
With the Berkus Method, the only financial projection you’ll need to make is the potential of your startup to generate over $20 million in revenues by your fifth year in business. Once a company is generating cash, this method is no longer applicable.
Scorecard valuation method
You can also use the scorecard valuation method. This is where you assign a weight to five to seven key factors. Add them up to arrive at an overall multiplier. This is applied to a comparable market transaction.
Here are six factors you might choose:
- Team quality
- Market size
- Disruptive potential
- Technological differentiation
- Market competition intensity
- Marketing and distribution strategy
- Customer feedback
A venture capitalist firm would assign weights to each of these factors and compare them to competitors. You’d get the factors for each category by multiplying the weight for each category by the startup’s relative position.
For example, if you thought “team quality” should be weighted at 30% and your startup was at 125% in this area compared to peers, the resulting factor would be 0.375 (30% x 125%). Add up all the individual factors to get an overall factor. In our hypothetical example, we’ll say the overall factor is 1.12.
If comparable peers have raised $5 million in funding, then the pre-money valuation for the startup would be $5.6 million ($5 million x 1.12). No two valuation approaches are going to result in the same valuation figures.
Let's say your startup is looking for $3 million in its series B round. Let's also say a VC is willing to accept a $7 million pre-money valuation set by your managers. Here's how you'd arrive at post-money valuation:
Pre-money valuation + Series B funding = post-money valuation
$7 million + $3 million = $10 million post-money valuation.
This means an investor would put in $3 million for a 30% equity stake in your startup ($3 million / $10 million) x 100%.
An investor must be sold on your valuation assumptions. If you think you’re being taken advantage of by the investor, you should walk away from the deal. Most investors aren’t unreasonable and will give your position due consideration. However, you’re going to need to do your homework on why your startup deserves a higher multiple.
The earlier the stage of the startup, the less proven the business model is. This means the risk is going to be higher and the startup valuation will be lower.
Add value by hiring the right people
One excellent way to add value to your company is by hiring the right people.
Hunt Club has the resources, the expertise, and the technology to build you a talent pipeline you can be proud of.