Why Entrepreneurs Should Understand How to Value a Startup
Valuation of a startup provides the business’s value expressed in monetary terms, and the calculations have a critical impact on the company’s ability to navigate growth stages. Indeed, this process might be challenging as these estimations are highly contextual, and require accounting for factors that affect a startup’s value. Business owners should conduct startup valuation for the following purposes:
- Valuation is essential for investors’ decision-making, as professionals may opt for securities while the financial metrics are critical for assessing the company’s revenue potential and risks.
- Valuation allows entrepreneurs, employees, and investors to distribute equity, predetermining the ownership of a startup.
- Startup valuation is critical for setting realistic expectations and business objectives, which guide budgeting, forecasting, and growth planning.
- Valuation is necessary for tracking a startup’s performance, especially scaling, as entrepreneurs should know if their project is increasing or decreasing in value.
- The valuation of a startup is the backbone of an exit strategy, which supports negotiation on the company’s sale price, terms, and future stakeholder agreements.
Therefore, by mastering how to calculate startup valuation, founders and investors can establish a solid foundation for making informed strategic decisions required for sustainable growth and long-term success.
How to Calculate Startup Valuation: Main Difficulties
Valuation of a startup is challenging, especially in the early stage of startup. While it is possible to evaluate market opportunities or main competitors’ performance, businesses that lack historical information face difficulties in calculating the startup’s worth. Additional challenges include, but are not limited to:
- Subjectivity and Bias
- Funding Round Types
- Future Performance Risks
- Overreliance on Startup Valuation Methods
- Market Timing
- Regulatory Uncertainties
- Limited Comparables
Entrepreneurs should also consider the increasing impact of geopolitical uncertainty with increasing competition in trending markets. One may compare the startup valuation process to art since the calculations heavily rely on interpretation rather than rigid formulas only.
How to Value a Startup: Commonly Used Methods
1. Venture Capital (VC) Method
In contrast to other common startup valuation methods, the VC method is useful for startups with a focus on scaling rapidly and achieving high growth. This approach is also suitable for investors who prioritize exit within several years. To perform calculations, entrepreneurs should follow the next steps:
- Estimate the startup’s terminal value (future expected selling price).
- Estimate anticipated ROI by a VC firm.
- Calculate post-money valuation by dividing terminal value by anticipated ROI.
2. Discounted Cash Flow (DCF) Method
This method is suitable for startups with established cash flows, including revenue and clear financial history, and it is highly recommended to work with analysts from startup valuation services. This approach allows business owners to make forecasts based on discounted cash and projected revenue. From an investor’s perspective, it is preferable to focus on companies with consistent revenue instead of startups with high-risk moves, and the DCF allows entrepreneurs to see how risky is their enterprise-based valuation of a startup.
3. Berkus Method
The Berkus method complements the list of startup valuation methods with its highly useful formula for early-stage and pre-revenue startups. In turn, entrepreneurs should consider five metrics that contribute to success in startups from the same niche. It will be necessary to assign a dollar amount to each category, keeping in mind the maximum valuation cap of $2 million for pre-revenue startups and $2.5 million for post-revenue startups. This simplistic tool is important for drafting initial startup valuations.
4. Scorecard Valuation Method
Scorecard valuation is another simplistic approach to startup valuation, which can be useful for pre-revenue companies. Compared to the Berkus method, this valuation strategy involves more steps to complete calculations. Thus, business owners should complete the next steps:
- Determine your startup’s average pre-money valuation.
- By using standard qualities, it is necessary to review their weightings in percentages.
- Assign a comparison percentage that can be on par, stronger, or weaker than average.
- Convert standard qualities (step 2) and comparison percentage for each category (step 3) in decimals and multiply the results.
- Sum up all the acquired scores (step 4) and multiply them by the average pre-money valuation (step 1).
5. Comparable Transactions Method
This startup valuation method uses precedents from the same market or industry to complete the estimations. The idea of the comparable transactions method is to refer to successful cases by replicating and applying their logic to your business, while minor adjustments will make the valuation more accurate and realistic. Startup founders should complete these steps:
- Look for similar startups from the same market or industry.
- Choose and use a common valuation metric (price per user, revenue multiple, or EBITDA multiple); for example, if a SaaS solution was acquired for $2 million and had 70,000 users, then the value per user would be $28.57.
- Apply this value to your startup. If you have 50, 000 users, the valuation will be $1,428,500.
- Adjust the valuation (step 2) by applying the discount if your startup cannot outperform the compared company.
Another professional recommendation is to use startup valuation services for getting the investor-ready assessment of your company’s worth based on this method.
6. Book Value Method
In contrast to the overviewed methods, this approach is fitting for asset-heavy companies or liquidation scenarios. The method has a simple equation formula for subtracting liabilities from assets. Thus, if your startup manufactured goods or had a complex hardware infrastructure, this method is a suitable choice for scenarios involving liquidation or sale of these assets.
7. Risk Factor Summation Method
Risk factor summation perfectly works with other startup valuation methods by setting a baseline valuation. This method is relevant for early-stage startups that want to get a realistic valuation through coherent risk assessment. Business owners should follow the next steps to complete the calculation:
- Use scorecard valuation, comparable transactions, or the Berkus method to estimate a baseline valuation.
- Review 12 risk areas.
- Assign risk grades and subtract or add money depending on risk level.
- Complete the adjustment of a baseline valuation.
It is highly recommended to avoid an over-optimistic assessment of risks since investors are likely to take a more critical perspective.
8. Cost-to-Duplicate Approach
If founders want to launch asset-heavy startups or have early-stage ideas, the cost-to-duplicate method will be a simple but effective approach to calculating valuation. By ignoring tangible assets, business owners should add the costs of physical assets based on their current market value. It is possible to include additional costs related to research and development, prototyping, and patent costs. However, this approach is highly nuanced compared to other startup valuation methods, making it useful for startups focused on technology or hardware development.
Professional Recommendations for Startup Valuation
The shared methods will provide the information needed to raise funds for a startup, which helps founders present a clear, credible valuation to potential investors. In regard to the above-mentioned challenges, there are several recommendations that can help improve the startup valuation process. They can be summarized as follows:
- Do not hesitate to use startup valuation services.
- Combine several startup valuation methods.
- High valuations lead to high expectations, making your startup valuation less realistic.
- It is reasonable to try convertible notes and SAFEs when raising funds from private investors.
- Consider your startup’s reputation, team experience, and product when presenting the startup’s value to investors.
Early-stage startups might include startup valuation in pitch deck presentations. However, it is important to note that some investors offer their valuation, while early discovery conversations should test their interest first.
Final Thoughts
Startup valuation methods provide calculations necessary to evaluate the startup’s worth in a holistic manner. A precise valuation will justify investments and strengthen investor’s trust in the business. Nonetheless, valuations are not fully accurate, and some entrepreneurs value their startups by funding stage. An additional suggestion is to develop a holistic approach to raising funds for your startup by using this guide. Entrepreneurs should accept this challenge as an opportunity to develop essential skills by reflecting on their business ideas from different angles.
Frequently Asked Questions (FAQ)
Q: What are the alternatives to startup valuation services for early-stage companies?
A: Yes, founder-investor negotiations can be an alternative to these services, while accelerators and incubators offer standardized funding, delaying valuation, and enhancing startup credibility.
Q: Should entrepreneurs consider intellectual property in addition to intangible assets when calculating startup valuation?
A: Yes, these assets can significantly boost investor confidence by strengthening the startup’s credibility.
Q: Can stage-based funding rounds serve as a reliable reference, making formal startup valuations unnecessary for business owners?
A: No, it is recommended not to rely on stage-based funding amounts as a reference for valuation. Some pre-seed startups can raise up to $2 million.
