As an entrepreneur, you should take the time to understand what are the methods of valuation.
Calculating a startup’s value is often a guessing game as you go into your first few funding rounds.
Pitching to investors for capital to grow and meeting their expectations can be a challenging process. As can be getting the best price for your company.
You might be thinking that valuation is all about the money when in reality, it is so much more than that.
Investors also consider the competitor’s performance, product, the team’s expertise, market opportunity, and so much more.
If you have concrete numbers, and revenue to show investors, it is easier to sell yourself. But your startup is only worth what you agree it’s worth during fundraising rounds.
Investors have various methods of valuation to find what a business is worth before they make the big decision to provide you with the capital you need.
Or when considering acquiring your company. Before we delve deep into valuation methods, let’s look at the meaning of business valuation.
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What is Business Valuation?
The method of determining the worth of a company is called a business valuation.
You, investors, and acquirers can take various approaches when calculating the valuation, and each one has its own objective assessment in doing so.
These methods will often start by including the available equipment, liquid assets, property, share price if you have one, and anything that has economic value.
Valuing any business is often a complex process, but here are a few situations where you would want to do so:
- If a company owner wants to sell the business
- If there is a merger between your business and another
- When the owner is looking to acquire another business
- If the partners want to establish ownership percentages
- If you are adding shareholders
- When a startup is seeking financing or investors
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Startup Valuation Methods Explained
When valuing your startup, look to your team to help identify the strengths and weaknesses of your company. Who knows it better than the heads of each department.
In addition, there are online resources that you can utilize that will help compare your company with similar businesses to get an estimate of your valuation, such as AngelList and Crunchbase.
Read ahead for a quick understanding of what are the methods of valuation for startups.
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.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
1. The Berkus Method
The Berkus Method was developed by Dave Berkus in the 90s – the famous venture capitalist and angel investor.
The kind of startup that this method suits the most are those in the early stages that are not selling their products or services yet, so there is no revenue to show.
More than 90% of startups fail and don’t live up to investor’s expectations. They are often caused by targeting the wrong demographic, failed partnerships, lack of funding, and failed marketing strategies.
The Berkus Method is a valuation method intended for startups to reach their funding targets to help them succeed by valuing the company from a risk perspective.
The Berkus Method uses the following five drivers for valuation, and each one has a maximum of $500,000 to prevent overvaluation.
will then value the company up to $2.5 million with revenue and $2 million without revenue.
- Sound business idea
- Partnerships with clients and suppliers
- Available prototype
- Skilled management team
- Product sales
The main drivers are the risk factors that can either make or break the business, so it is essential to manage them carefully if you want to see it succeed.
As the risk decreases, the value of the company increases. If a company has recurring revenue, the Berkus Method may not give you the maximum value.
Though it can give you a boost as a startup with little to no revenue.
2. Comparable Transactions Method
This is one of the most commonly used methods of valuation for startups. It gets based on what investors valued other startups that are similar to yours.
For example, assume there is a photo editing app that recently got acquired for $14.5 million. The app has 500,000 registered users, and the price per user is $29.
You currently have 200,000 users for $25 per user. Your startup may currently get valued at $5 million. Compared to yours, the companies will have a similar product, business plan, and price per user.
Investors may see discrepancies in the company’s value as an opportunity to undervalue the startup to hold onto the equity for when the value increases.
While the method values startups by comparing them to others in the same market, other multipliers that aren’t comparable will still be considered.
3. Scorecard Evaluation Method
The Scorecard Method of valuation is similar to the Comparables Method. Investors will compare your business with those that have already gotten funded.
The Scorecard Method is also known as the Bill Payne valuation method and is most commonly used by angel investors.
They will compare the startup based on its current market, region, and stage of development, which can significantly impact the startup’s valuation.
Stack up your startup to other businesses in the same market by the following:
- Quality of the management team: 0-25%
- Size of the opportunity: 0-20%
- Product or technology: 0-20%
- Marketing, sales, and partnerships: 0-15%
- Need for financing: 0-10%
- Other: 0-10%
Investors will adjust the percentages according to their preferences, but these are considered subjective to startup ventures.
Thus, each of the points can be scored below, above, or equal to 100% compared to the startup’s competitors.
4. Cost-to-Duplicate Approach
The Cost-to-Duplicate valuation method is just that – how much will it cost to recreate your business elsewhere.
The physical assets get tallied at a reasonable market price, which will include all the data from research of development, patent, and prototype costs.
The main objective of the method is to determine the startup’s competitive advantage in the current market.
You will gather all existing expense reports to provide a reasonable estimate of costs. Tough, it won’t take into consideration future sales, intangible assets, or ROI.
One of the main disadvantages of this method is it won’t effectively capture the total value of the startup, especially if you are earning revenue.
5. Venture Capital Method
Venture capital firms commonly use this method during the pre-revenue stage and are the best option for those who want to leave the company at a future date.
This is one of the methods of valuation and uses the following formula:
Pre-money valuation = post-money valuation – invested capital
For example, suppose your startup gets valued at $2 million and investors want a 20 x return on a $20,000 investment. In that case, the post-money valuation is $100,000 ($2 million ÷ $20,000 investment), and the pre-money valuation will look like this:
Pre-money = $100,000 – $20,000 = $80,000
6. Discounted Cash Flow Method of Valuation
The Discounted Cash Flow Method determines the value of a company based upon its projected cash flow discounted to its current value.
Investors also call this method the income approach and are useful when you know the profits won’t stay the same in the future.
Many startups seek help from market analysts to use the future cash flow and apply the discount rate.
If the discount rate is high, it is a good indication that the investment risk is higher. Investing in a startup can be considered a high risk to begin with compared to businesses that have already been earning revenue consistently.
When conducting a Discounted Cash Flow valuation, the investor will determine the estimated future cash flow with the end value of their investment.
They will also need to calculate a suitable discount rate for the valuation. This is one of the methods of valuation that will prove handy for an entrepreneur.
7. Risk Factor Summation Method
Intended for early-stage startups, the Risk Factor Summation Method relies on estimations of the various risk factors that must be addressed.
Here are the 12 main risk factors:
- Management risk
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
The first step for the risk factor summation method is with the initial valuation based on another method.
Then the investor will decrease or increase the valuation in increments of $250,000 based on the 12 risk factors that affect the company.
All the low-risk elements will get a ++ grade, meaning you will add $250,000 + $250,000 to the valuation. All the high-risk elements will get a – – grade, meaning you will deduct $500,000.
For best practices of this valuation method, only use for pre-revenue startups and more than one method to get a more accurate valuation range.
Would you like more detailed information on how to value your company? Check out this video I have created where I explain in detail how it’s done.
Benefits of Valuation Methods
These seven valuations are just a few that exist for startups. In addition, there is the Capitalization of Earnings Valuation Method, Multiples of Earnings Valuation Method, Book Value Valuation Method, and many more.
If you haven’t had an assessment to determine the value of your startup with various valuations, now is the time to start.
Having multiple, consistent valuations gives the founders facts and figures on what they are worth. The valuation is not a once-off process that should get done for startups.
All businesses should perform a valuation yearly to keep track of company growth. Let’s explore more benefits of business valuations:
- Reinvesting: A valuation is needed for funding rounds and how much you want to reinvest into the company.
- Know your resale value: Selling your startup is a strong motivator for many founders. However, the valuation must get done before being put on the market for sale—the opportunity to make more money increases because you can negotiate higher prices.
- Obtaining an accurate company value: While getting a perfect valuation is not entirely possible for a startup as it is both art and science, your goal is to get the value close with or without consistent revenue.
- Acquisitions and mergers: Never walk into an acquisition or merger meeting without a valuation. By showing growth from year to year with current assets helps prevent investors or acquirers from undervaluing your company, and you can also reject offers to continue the negotiation process.
- Access to higher quality investors and acquirers: A good valuation will attract people who will pay big money to be part of your company. When searching for investors during different phases of your funding rounds, they will want a full company valuation with the data on how you came to those numbers.
Finding a Valuation Professional
Working with a startup valuation professional will ensure you get the best possible valuation for your business with professional reports and data to back it up.
There are intricate calculations involved, and getting them wrong could cost you the investment or sale.
A valuation expert will provide an objective valuation using multiple methods to ensure you know what your business is worth before an important investor meeting.
The Bottom Line
When you have concluded your valuation for your business, begin to set goals for the coming year on ways to increase its value.
Then, each year, compare the worth from the year before and measure its growth and losses. Look for where there is room for improvement and work on them for the year ahead.
Choose from the different methods of valuation and find the one that works for your startup. Are you in the pre-revenue phase? Are there various competitors in the market to compare your business to?
When determining your company’s worth, it is easy to be biased, so hire an outside professional business appraiser to get the most accurate valuations.
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