Every entrepreneur should know how investors value startups. The rise of entrepreneurship has spawned one of the most extensively used expressions in business and finance history: ‘startups.’
A startup is a smaller company that started with an idea and is keen to grow fast. It is often currently looking for funding to expand and mature.
Startups require funding to grow, test ideas, and build a team. They must be valued to raise funds.
So understanding how the startup valuation process works is critical for any serious and committed founder. As well as their potential investors.
Financial analysts can use a variety of startup valuation methods. Read further to learn some of the most common strategies for valuing startups.
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The Importance of Estimating the Startup’s Value
A new startup can only go so far as the funding to develop its core concept or idea fully. A startup without money is doomed to fail.
So, raising financing for your company is one of the most critical activities you may find yourself doing as the founder. You’ll also focus on growing the technical side of the business and marketing,
As a startup, you’ll need funding for the following:
- Prototype development
- Office space
- Hiring of staff
- And much more!
Determining the value of your new startup is important to propose your idea to an investor. They’ll want to know how much your startup is worth, and to justify your ask.
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The Most Common Valuation Methods for Startups
Several methods for valuing a company are available to venture capital firms and individual investors. These range from the simplest to the most complicated.
Venture Capital Method
Venture capital firms often use this method, and it’s an alternative if you require a pre-revenue valuation. It also represents the mindsets of investors who want to get out of a company in a few years.
The formulas that you’ll use when determining your valuation through the Venture Capital Method are as follows:
Pre-Money Valuation = Post Money Valuation — Invested Capital
Post-Money Valuation = Terminal Value / Expected Return
A startup valuation uses an anticipated terminal value for the startup. And, an expected return from the investor (typically specified as 10X, 8X, etc.) to determine pre-money and post-money valuations.
American venture capitalist and angel investor Dave Berkus developed the Berkus Approach.
After giving the entrepreneur some fundamental credit for the quality and potential of the idea itself, the Berkus Method provides a number.
You’ll arrive at a financial valuation, to each of four primary elements of risk all early enterprises face.
Today, the strategy adds $500,000 in value to each of the risk-reduction factors listed below:
- Sound idea
- Quality management team
- Strategic relationships
- Product rollout or sales
Investors carry out a complete thorough analysis to determine how much value the five main success criteria provide to the enterprise’s total worth in quantitative terms. The startup is valued based on these figures.
“The Stage Development Method” or “the Development Stage Valuation Approach” are other names for the Berkus Method. Understand how this method works when figuring out how investors value startups.
The cost-to-duplicate method entails determining how much it would cost to start a similar company from the ground up.
The concept is that a sensible investor would not pay more than it would cost to recreate something. This method frequently assesses the physical assets to determine their fair market value.
The cost-to-duplicate method has the following disadvantages:
- By running projection statements of future sales and growth, the company’s future potential does not get considered.
- Not considering its intangible assets in addition to its tangible assets. Even at the startup stage, the idea is that the company’s intangibles may have a lot to offer for valuation. These may include goodwill, brand value, intellectual rights (if any), etc.,
Discounted Cash Flow Model (DCF)
The Discounted Cash Flow (DCF) Method focuses on forecasting future cash flow movements for a startup.
The “discount rate,” or rate of return on investment, is then calculated and used to evaluate the value of the projected cash flow.
Because startups are still in their early stages and investing in them carries a high risk, investors impose a high discount rate.
The problem with DCF is that the analyst determines its accuracy according to their ability to foresee future market conditions. That’s how they create accurate long-term growth rate assumptions.
Before you move on to understand additional valuation methods, check out this video I have created. I have put together some detailed information on how to value your company.
Forecasting sales and earnings beyond a few years is frequently a guessing game.
Furthermore, the value generated by DCF models is largely dependent on the predicted rate of return used to discount cash flows. As a result, DCF must be used with caution.
The Comparables Method uses referential information and data from other similar transactions to assess the value in the new business venture.
Let’s look at an example:
Let’s say a venture capital firm recently valued a similar app to the one produced by the startup at $3,000,000. And the app had 100,000 active subscribers/users.
This means that each user was worth $30 to the company. An angel investor could use this benchmark to determine the value of a new startup with a similar application.
Valuation by Multiples Method
The Valuation by Multiples Method is one of the most often used for startups that have already made some money and are profitable.
Let’s imagine your startup generates a $300,000 EBITDA (earnings before interest, taxes, depreciation, and amortization).
An investor may value your business at 5X, 10X, or 15X your current EBITDA. That depends on the industry you’re in, your management team, your competition, and other qualitative factors.
Investors use this effective and simple valuation tool to evaluate a more mature startup’s value swiftly.
Future Valuation Multiple Approach
Every entrepreneur should take the time to understand how investors value startups. The Future Valuation Multiple Approach purely focuses entirely on calculating the return on investment.
Or the returns that investors might expect in return, such as in the next five to ten years.
Several estimates are made, including five-year sales projections, cost and expenditure projections, growth projections, etc. And the startup is valued based on these future projections.
Market Multiple Approach
This strategy appeals to venture capitalists. That’s because it provides a good indicator of what the market is prepared to pay for a startup.
Essentially, the Market Multiple Approach compares the company to prior market purchases of similar companies.
Assume that mobile application development companies are selling for five times their current sales.
Knowing what real investors will pay for mobile software, you may use a five-times multiple as a starting point. That’s how you’ll value your mobile app startup, changing the multiple up or down to account for other factors.
Given that investors are taking on that added risk, your mobile development startup would presumably fetch a lower multiple than five.
That is if it were at an earlier stage of development than other comparable companies.
For you to evaluate a startup in its early phases, you must make comprehensive predictions. This is essential to establish its sales or earnings once it has reached maturity.
Providers of capital will frequently provide funding to startups. That is if they believe in its product and business model, even if it is not yet profitable.
While earnings decide the value of many established companies, revenue multiples determine the value of startups frequently.
According to some, the Market Multiple Approach produces value estimates near what investors are ready to pay.
Regrettably, there is a snag: similar market transactions can be challenging to come by. It’s not always easy, especially in the startup world, to locate comparable companies.
Early-stage, unlisted companies frequently keep deal terms under wraps, which are likely to be the most similar.
Risk Factor Summation Approach
The Risk Factor Summation Approach is a more comprehensive approach to determining the worth of your startup.
Begin by estimating the value of your startup using one of the various methods described above. Then, based on the risks that affect your startup, increase or decrease that monetary value in multiples of $250,000.
Low-risk factors get a double-plus grade (++). That means your valuation increases by $500,000. A double-minus grade (–) gets allocated to high-risk factors, and you deduct $500,000.
Say, your online bespoke clothes store business, for example, has a slight but minimal danger of competition. You can rate it positively but only add $250,000.
Learning how investors value startups will give you a better chance at acquiring funding.
These are the 12 most common risk categories:
- Stage of the business
- Manufacturing risk
- Legislation/political risk
- Funding/capital raising risk
- Sales and marketing risk
- Technology risk
- Competition risk
- International risk
- Litigation risk
- Potential lucrative exit
- Reputation risk
Finding an objective guideline to measure each section is the most challenging part of this approach. It may help to start with a Comparable Method first.
Keep in mind that in fundraising, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
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Choosing the Right Valuation Method for your Startup’s Stage
Startups go through various stages, the instant an idea is conceived until the startup’s point has evolved into a fully operational business.
Each of these startup valuation models for your business is better suited to certain stages than others. So you’ll need to determine which stage you’re in before choosing the method that’s right for you.
Here’s a rundown of the four stages that most startups go through:
For any new business startup, the Seed stage is the first stage. There is usually no revenue, no assets, no team, and no business at this phase. All you need is an idea and the willingness to take the step forward.
The Berkus Method or even the Venture Capital Method may be the best option for you at this point.
Series A Stage
Your new business is now a viable concept on the move. By now, you most likely have a beta product or a prototype, or you’ve made some sales.
More technical approaches, such as the Cost-to-Duplicate method or even the Venture Capital Method, can be used at this point.
Be mindful that what you’ve done so far may not be indicative of what’s to come. So don’t undervalue your company by treating current data as if they were your startup’s final performance indicator.
Take the time to understand how investors value startups.
Series B Stage
Money is needed at this time to grow and continue expanding. By now, you’ve established the company strategy, and you can estimate your revenue-generation potential.
You can now use various company valuation methods that are heavily reliant on financial data to arrive at a figure. The Discounted Cash Flow Model and the Valuation by Multiples Model are two of these methods.
Several further advanced phases are closer to an IPO. Still, because getting to those stages requires significant advance and advising, you may not need this guide at that point. Similar to advisors and investment bankers who can value the business.
How Much You Can Expect to Raise at Each Round
How much you can expect to raise at each stage is dependent on a number of things.
These factors include your ability to craft a great pitch deck, your network, and the viability of your idea/business concept. Market conditions and market trends are other factors
Some definitely smash these numbers with record raises, as you’ll see documented on the Dealmakers Podcast. However, you can expect to raise a sum that falls within the following ranges:
- Seed Stage: Between $250,000 and $2,000,000
- Round A Stage: Between $2,000,000 and $15,000,000
- Round B Stage: Between $15,000,000 and $50,000,000
The Bottom Line
Models for valuing startups are only estimates. There is no perfect way to value a startup with almost no assets.
Nonetheless, the approaches and facts described in this article can offer you a good notion of what you should expect and ask for your startup.
There is no one single strategy for valuing a startup that is 100 percent right all of the time. To arrive at a reasonable price, you’ll most likely need a combination of methods and procedures.
Don’t forget to use company databases to double-check that you’re on the right track.
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