Startup Company Valuation Methods: How Startup Company Valuation Works And Its Importance For Entrepreneurs
Raising funds is somehow an unavoidable part of any startup’s journey. And to establish a successful business, startups need to go through multiple funding rounds.
Not just funds, but the timing of funds is also very important.
If you take too much time to get funded, you are likely to be welcomed by increased competition in the market. And if you get it too early, it can put your startup at the risk of not being relevant in the market.
But this is just a teeny-tiny part of the picture. What if the timing is right, but the funds are insufficient.
In this situation, the only option left is external funding sources like VCs, angel investors or other startup enablers. But to approach any of the above-mentioned external sources, startups first need to figure out their value, i.e. how much they are valued.
Startup Company Valuation helps in determining the fair amount of equity startups have to give to an investor in exchange for funds. But this is just the perspective of the startup.
For an investor, things like related risk and ROI are important. Therefore, evaluating the fair value of a startup is important for all the parties involved.
Now, this leads to a quite obvious question, i.e. how a startup is valued and why it is important to calculate the value of a startup.
Before we proceed any further, let’s discuss this process in a detailed manner.
What is Startup Company Valuation?
Startup Company Valuation is the process of evaluating the worth of the startup using some startup company valuation methods. The valuation process holds importance for startups and entrepreneurs as it helps determine the fair amount of equity they have to give to an investor in exchange for funds.
The process holds the same importance for investors as they need to know what percentage of shares they will receive in return for the amount they have invested.
Why is it important to estimate the value of a startup?
Company Valuation is a relative thing and is generally determined by analysing the sector to which the startup belongs, the future of the industry, the size of recent startup exits in the industry, etc.
Sometimes it depends on the willingness of an investor to pay a premium to get into a deal. And sometimes, the desperation level of the entrepreneur looking for money is so high that they undervalue their startup to get the money needed.
In general, startup founders hope for a high valuation, whereas investors prefer a discounted value that promises a huge return on investment (ROI).
You would have understood by now the importance of fair evaluating the value of a startup, and it does not involve any guesswork.
That is why it becomes important for founders to have proper knowledge about the entire process of startup company valuation.
For Instance: If you quote a high figure to investors, as compared to the fair value, you won’t be able to meet the set targets. And generally, this leads to lower valuation in the next funding round.
It can also cause a negative impact among other investors regarding your startup, and you may face issues in convincing investors for funding.
And if you quote too low, you may end up giving a large portion of startup equity to investors.
Now, you may be thinking what’s the right way to get the fair value of a startup.
Keep in mind, startup company valuation is an intricate part, but there are several available industry metrics used to find the fair value for a startup. So, below written are some factors which investors and entrepreneurs take into consideration before deciding the valuation of a company.
Calculating the company valuation of a startup also becomes difficult, as, unlike mature companies, early-stage startups don’t have more firm facts and figures.[Read: Importance Of Financial Modelling For Startups & Small Businesses]
Factors Influencing The Company Valuation Of Startups
1. Startup’s Reputation
A positive image of the company is important for an entrepreneur to survive and grow in the market. The reputation of your startup is one of the most important aspects an investor looks at before investing.
So, make sure whatever thing your startup offers has positive reviews in the market. Before proceeding ahead with the round of valuation, founders need to ensure a positive impact of their startup in the market.
Traction refers to the progress your company has made or the momentum your company has attained over a period, keeping in mind its potential customers.
It provides quantitative proof of customer demand and shows that your startup is progressing in the right direction.
If your just starting, make sure to develop a prototype. A prototype plays a key role and can influence the decision of an investor. Have a prototype or a minimum viable product ready before valuating your startup.
4. The Industry
The industry to which your startup belongs plays a key role in deciding in fair company valuation of your startup.
If the startup belongs to a sunrise industry, investors will likely pay a premium. That is why it is important to choose the right sector, as it will influence the valuation of your startup.
Some other factors like pre-valuation revenues, market size, distribution channels, competitors, etc., play a major role in deciding the fair value of a startup.
For Instance: If your product is only suitable for people living in Delhi, the Company valuation will be lower than if your potential market is India or globally.
Now that you know about the factors influencing the company valuation of startups, let’s talk about some startup valuation methods.[Read: Growth Story Of Indian Startup Ecosystem And Top 5 Most Promising Sectors In 2021]
Startup Company Valuation Methods
There are several startup valuation methods used by financial analysts to get the fair value of a startup. Below-written are some popular methods used for valuing startups.
1. Startup Company Valuation Using The the Berkus Method
Named after angel investor Dave Berkus, the Berkus Method follows both qualitative and quantitative approach in deciding the valuation of a startup.
The Berkus Method works by assessing how your startup will perform in the five key criteria by assigning a number, a financial valuation, to each criterion.
These five criteria are
- Sound Idea (basic value)
- Prototype (technology)
- Quality Management Team (execution)
- Strategic Relationships (go-to-market)
- Product Rollout or Sales (production)
$500K is the maximum value that could be earned in each criterion, giving the possibility for a pre-money valuation of up to $2M-$2.5M.
For Instance: If an investor thinks that the founders have deep domain expertise in their respective field, he may assign a $500K value corresponding to ‘Quality Management.’
As quality management reduces the risk related to execution, the investor has given $500K value to it.
Similarly, each criterion is given value and based on the value, the approximate pre-money valuation of the startup is deducted. Like, if the startup’s prototype is sound and has minimal technology risk, the investor may give a $400K value to ‘Prototype.’
- Sound Idea (basic value)= $400K
- Prototype (technology)= $400K
- Quality Management Team (execution)= $500K
- Strategic Relationships (go-to-market)= $350K
- Product Rollout or Sales (production)= $350K
Here, the investor has given a pre-money valuation of approximately $2M.
To read more in detail about the Berkus Method, click here.
2. Startup Company Valuation Using The Risk Factor Summation Method
Unlike the Berkus method, where startup company valuation is done using only five key criteria, the Risk Factor Summation Method (RFS method) considers a wide range of criteria to reach the pre-money valuation.
In this method, the initial value of the startup is determined by assessing similar startups. After that, risk factors are factored in this value as multiples of $250K.
These multiple risk factors range from a low-risk value of $500k to a high-risk value of -$550k, i.e. a value is added or subtracted to the initial value as per the risk involved.
Different risks that this method considers are:
- Stage of the business
- Manufacturing risk
- Sales and marketing risk
- Reputation risk
- Technology risk
- Competition risk
- International risk
- Legislation/Political risk
- Litigation risk
- Funding/capital raising risk
- A potentially profitable exit
3. Startup Company Valuation Using The Discounted Cash Flow Method
This valuation method applies to startups that are generating cash flows, and there is a certainty of cash flows in future.
In the DCF Method, future free cash flows are estimated and discounted to the present value. And if the value obtained from this method is greater than the cost of investment, the investment opportunity is a positive one.
Click ‘Discounted Cash Flow Method‘ to know in detail about the method.
4. Startup Company Valuation Using The Venture Capital Method
First outlined by Professor Bill Sahlman in 1987 at Harvard Business School, the Venture Capital Method is implemented from the viewpoint of the investors.
In this method, valuation is done based on two things:
- Expected ROI
- Expected Sale Value after X years
Let’s assume an investor goes into a startup deal with a 20x return on investment, and he/she assumes that the startup could be sold for $200M in 8 years.
Based on these estimates, the investor can determine the maximum price she/he is willing to invest in the startup after adjusting for dilution.
Post-Money Valuation = $200M/20x =$10M
- $10M-$2M =$8M
- $8M (1-0.35) =$5.2M
- $200M = Anticipated Exit
- 20X = Target ROi
- $10M = Post-money valuation
- $2M = Amount Invested
- $8M= Pre-Money valuation before adjusting for dilution
- 0.35/35%= Anticipated Dilution
- $5.2M =Pre-Money valuation after adjusting for dilution
You can read more about the Venture Capital Method here.
Some other common methods used for startup company valuation are Scorecard Valuation Method, Comparable Transactions Method, Book Value Method, Liquidation Value Method, and First Chicago Method.
Valuations are important for both startups and investors, but valuations are nothing more than formalized guesstimates. They are just a good starting point when considering fundraising.
Valuation never shows the exact value of your startup. So, one should never use a single approach to calculate startup valuation. To have a more accurate valuation, use multiple methods.
And as it an intricate process, you must take the help of an experienced financial analyst. If you need help in your startup valuation, contact us.[Read: Step by Step Guide to Register a company In Delhi]