Ready to have your startup valuation methods explained? As an investor, one of the most critical pieces of information about a startup is its worth.
As a startup, you must determine your current or projected worth without over or undervaluing yourself.
Valuations for startups are often solely speculative because you have to forecast the future. And the numbers based on potential income when the company reaches maturity.
This can be a painstaking process, and you must get it right because it could mean the success or failure of getting funding.
There are various techniques for determining your company’s valuation, and each one will have a different conclusion. When you present your numbers to investors, show the potential behind your company and how you come to that valuation.
Often there is little or no revenue, making it more difficult to provide an accurate valuation.
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What to Consider When Choosing a Startup Valuation Method
The first thing to understand is other companies in the same industry and their geographical location. Do thorough research and find out their valuations. That’s because it will help you determine which method is best for your business.
Various valuation methods require this information to value your own startup.
Don’t deliver on one approach. Use several valuation methods because one might not prove to be useful. While it will never be perfect, investors will want to see your commitment to research and the accuracy of the numbers.
If you want to establish good investment terms, you must present them with exactly how you came to the valuation of your startup. Let’s explore the different startup valuation methods and how they can influence your investment options and impact your equity.
Venture Capital Method
The Venture Capital Method shows the pre-money valuation of startups. Professor Bill Sahlman from Harvard Business School developed this method in 1987. The following formula is used:
(ROI) Return on Investment [equals] Terminal (or Harvest) Value [divided by] Post-money Valuation
Post-money Valuation = Terminal Value ÷ Anticipated ROI
The terminal value is the projected selling price in the future using the expected revenue in the year of sale and estimated earnings.
Let’s use a real-world example. If you have a tech startup and the terminal value is $2 million, there is an estimated ROI of 20 X. You need $100,000.
- Post-money Valuation = Terminal Value ÷ Anticipated ROI = $2 million ÷ 20X
- Post-money Valuation = $400,000
- Pre-money Valuation = Post-money Valuation – Investment = $400,000 – $100,000
- Pre-money Valuation = $300,000
Take Dilution into Consideration
Assume the startup will require further funding before the investor’s ability to liquidate her stake. If they do not participate, they may be diluted by the subsequent issuance. The investor can try to mitigate the risk by seeking anti-dilution protection.
There are limitations to the Venture Capital Method. Although it is the leading method by investors and startups for early-stage investments, it still relies on projected growth and future revenue, making it speculative.
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Cost To Duplicate Method
The cost to duplicate is a good place to start when finding your valuation. This method aims to discover the total amount needed to start the company from scratch and questions the startup’s competitive advantage.
That’s how it gets its name “cost to duplicate.” If the cost to duplicate the business is low, then your valuation is low. Although, if it is costly to replicate the business model, your valuation will be higher because of its complexity.
For example, let’s assume you are a tech company. The valuation gets estimated according to how much it will cost to research, develop, and create a product prototype. The startup’s infrastructure and tangible assets are included in determining value.
The cost to duplicate method considers all the company’s expenses to determine its fair market value, but it has some limitations. These include:
- One of its main limitations is that it doesn’t include the future potential and only the present, for example, future sales and growth.
- You also don’t consider intangible assets when using this method. These can include the brand’s identity.
While there are limitations, the cost to duplicate method can be the foundation for other startup valuation methods.
90% of startups fail, and at least 21% will fail in the first year. They fail to live up to investor expectations, and the majority fail due to the lack of funding, insufficient market research, and failed relationships with their partners.
The Berkus Method was invented in the ’90s by Dave Berkus, a popular venture capitalist. This method values startups before their first revenues.
Dave Berkus created this method because of the poor track record startups have and that financial projections weren’t reliable. This method approaches a startup from a risk perspective. The Berkus Method applies to pre-venue startups.
The main factors of the Berkus Method:
- Valuable business model (base value)
- Available prototype (reducing technology risks)
- Skills and Abilities of the management or founding team (reducing implementation risks)
- Strategic Relationships (reducing market risks)
- Existing customers or first sales (reducing production risks)
|Value Drivers||Add to Pre-money Valuation|
|Valuable business model||$0 to $0.5 million|
|Working prototype||$0 to $0.5 million|
|Management team||$0 to $0.5 million|
|Strategic relationships||$0 to $0.5 million|
|Existing consumers or sales||$0 to $0.5 million|
The monetary sum of the value drivers equals the base pre-money valuation. Based on the amount of money chosen, the pre-money valuation of $0-$2.5 million.
The Berkus method allows for a maximum of $2.5 million or $2 million if there are no revenues.
Any venture capitalist looking at this valuation would need to understand pre-money valuations of early-stage startup competition for the industry they will be investing in because there isn’t a quantitative factor or performance number to work from.
Many entrepreneurs choosing their startup valuation methods often choose the Berkus method over the Venture Capital Method because it considers qualitative factors during the valuation.
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Discounted Cash Flow Method
The Discounted Cash Flow Method is a way of valuing a startup by projecting how much cash flow it will produce in the future.
The startup will determine the cash flow potential and how much time is necessary to repay the investment, and what the cash flow is worth.
The total value will then get discounted to compensate for potential risks, and this final number will be the valuation.
Calculating the present value under Discounted Cash Flow
Start by itemizing all the positive and negative cash flows. These include:
- The initial purchase
- Maintenance costs
- Working capital investment of the original purchase
- Profit on the sales of goods from the investment
- The sum of income tax protected by the depreciation on the obtained asset
- The working capital reduction that gets received when the asset is later sold
Establish the investor’s cost of capital. The cost of capital is the after-tax cost of the common stock, debt, and preferred stock.
Add the cash flow from the first step and the cost of capital from the second step into the calculation below to determine the present value of cash flows.
Then, add this formula into an Excel spreadsheet or financial modeling software to determine the total discounted cash flow.
Net present value = X × [(1+r)^n – 1]/[r × (1+r)^n]
X = The amount received per period
n = The number of periods
r = The required return (cost of capital)
To predict the future cash flow with absolute confidence, you would need some form of revenue to base the claims that most startups don’t have.
While this might be an unpopular valuation method, it still gets used with other methods as a starting point when valuing a company.
A limitation of the Discounted Cash Flow Method is that you will find it challenging to predict the company’s long-term growth rates. The further you predict the number in time, the more unreliable the valuation will become.
The Comparable Method is one of the easiest because it compares the startup to a similar company within the same market. You will find a comparable company and use its valuation as a foundation for your new startup.
If, for example, a startup in the same industry developed a similar app that has 100,000 users and a venture capital firm valued them at $2 million, the company is valued at $20 per user.
Investors will take this valuation and use it as a benchmark to value your startup. This approach is widely used in startup valuation methods because the numbers get calculated by current and new startups making the information more accurate.
Startup A is worth $2 million, and Startup B is comparable to Startup A, so the same valuation applies.
The limitation with this method is that there are rarely startups that are close enough to warrant this approach as the only valuation method. Although, for numerous investors, it gets seen as the starting point for measuring the pre-revenue state.
If you’re ready for more information about how to value your company, check out this video I have created.
Why are Startup Valuation Methods Important?
Early-stage investors need to know the startup’s value to determine whether they will invest or not and the likely exit size in the industry.
Therefore, when startups present the investors with high valuations and proof thereof, they are more likely to invest with a larger amount because the data shows its potential success.
Using various startup valuation methods is also essential because most startups don’t have reliable past performance data to present.
Instead, they have to base their valuation on guesswork and predictions, competition’s valuations, and related industry’s market research.
A startup should use various methods to have a sensible average amount to get the most accurate valuations.
For instance, let’s assume you are offering 15% of your startup for an investment of $150,000. The investors will know that your startup will be worth $1 million after the investment.
The Crux of it All
Performing and presenting valuation methods helps investors determine what amount of money to offer the startup.
Remember that while valuations are important to investors, much of the pitch is about showing them who is in charge and how passionate you are about the business. They are not just investing in an idea; they are investing in you.
Do you need to have a high valuation to be successful?
Startups don’t have to rely on very high valuations. In fact, it could be a burden if it is too high. If you are to receive a high valuation for your seed round, you will need an even higher one for the next round of funding.
That is a lot of pressure between the funding rounds. That means being able to achieve new milestones and consistent growth between rounds.
A common mistake that startups make is assuming that the valuation is accurate or permanent. Your startup is only worth what the investors are willing to pay for it, and you might not agree with their separate valuation.
Your valuation is essentially based on predictions, and you shouldn’t assume it is permanent. Startup valuation methods seem simple in theory, but it is never straightforward.
The valuation of your business is constantly changing, and it is important to be honest and forthright with your valuation process.
More and more venture capital firms and investors are ready to invest in new and innovative startup companies than ever before.
Fundraising may be a time-consuming and draining task, but you can get the desired outcome with persistence, confidence, and a killer pitch.
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