#EBITDA article series
A startup valuation is the process of estimating the value of a startup based on its tangible and intangible assets.
Common Startup Valuation Methods Explained
Ever wondered how Angels and Venture Capitalists evaluate the viability of a startup? How much do they invest? Or how do startup founders know the size of investments they qualify for? This is the world of startup valuations.
In this article, we will discuss the need and importance of valuation for startups and explore some common methods used in this process. Let’s start with the basics.
A promising startup is founded on a brilliant idea that aims to fill a gap in market needs. From its inception, a startup goes through several stages of growth and expansion towards realizing its true market potential. But no progress is possible without timely financial investments. Investments in turn cannot happen unless the startup is estimated for what it is worth based on its current status and future potential. Startup valuation methods thus are the foundation for attracting the much-needed funding for a startup.
What is a Startup valuation?
A startup valuation is the process of estimating the value of a startup based on its tangible and intangible assets. Analysts focus on its future growth potential as well. Investors and founders use various metrics to arrive at a near-exact estimation. But it is important to realize that a valuation for startups is a tricky process. A lot is based on projections and industry benchmark comparisons, especially in the case of startups in the pre-revenue stage.
A startup is a founder’s baby. Naturally, founders tend to overestimate their valuation and demand higher investments. While pitching to investors, one must note that a high valuation for startups must be complemented with a promising growth potential. As far as investors are concerned, they are looking for their next highest ROI. A high value startup without a realistic growth plan will fall short of their expectations. Plus, startup valuation figures must grow exponentially with every funding round. A high flying first round followed by a downsized funding round does not reflect well on a startup’s performance.
Why is it important to estimate the value of a startup?
Investments are the lifeline of every startup. Engaging any resource to enrich the company will come at a cost that a startup in its early stages is not equipped to bear. The next logical step is to approach investors for the required funds. An investor will fund a startup only if they see a scope of big profits in owning their equity. The Valuation of startups thus is the baseline used by investors to evaluate startup funding proposals.
Startup valuation methods vary with their stage of development. Different qualitative variables and statistical analytics are applied based on the position of a startup in its lifecycle. Before moving further into the nuances of startup valuation, let us look into the 4 basic stages of a startup and the extent of investment one can expect at each stage:
- Stage I – This is the ‘seed’ stage when a startup is still an idea backed by a talented founding team all set to take it further. In some cases, they might have managed to create a prototype as well. But a seed-stage startup will not have assets and minimal or no revenue. They have just bootstrapped themselves into the market. A typical seed-stage investment is in the range of $250,000 – $2,000,000.
- Stage II – Otherwise referred to as the ‘Round A’ or ‘Series A’, a startup by now definitely has a prototype and has generated some revenue in sales. With a Minimum Value Product (MVP) and some early adopters, investments at this stage are around $2,000,000 – $15,000,000.
- Stage III – This stage is also known as the ‘Round B’ or ‘Series B’. By this stage, a startup has proved its business viability and aims to expand profits based on established business models. Investments backing stage III startups are in the range of $15,000,000 – $50,000,000.
- Stage IV – Otherwise known as the ‘Series C’ round, a startup by now is generating multi-million dollars in revenue. A scale-up at this stage will either lead to an acquisition or IPO. Advanced metrics and valuation models are required at this stage to estimate the startup valuation.
As we see, startup valuation methods vary based on the stage of business development. Founders must strive to get it right from the start as every stage is a stepping stone to the next. Founders must be well equipped with suitable strategies to justify their company valuation before approaching investors. Apart from evaluating their own company, a keen understanding of competitors and industry benchmarks is also required to arrive at a justifiable valuation.
A realistic valuation of startups contributes to the transparency between investors and founders. Since startups by nature are a risky venture, investors have the right to know what they are getting into and founders must be valued for the business they are building.
Difference between startup valuation and mature business valuation
Valuation models for startups differ from those used for mature businesses simply because of their limitations with tangible data. Mature businesses are publicly listed and have considerable statistics supporting their operations, investments, reliable decision-making capacity, and revenues. Their performance reflects stability and makes it easy for investors to analyze their profit potential. The value of such companies can be easily estimated using the EBITDA formula that calculates the value based on the company’s earnings before interest, taxes, depreciation, and amortization.
EBITDA = Net profit + Interest + Taxes + Depreciation + Amortization
However, startup valuation methods for a pre-revenue company cannot involve just one linear formula. It demands a comprehensive judgment of several factors, most of which are determined by market forces. Let us take a look at some aspects that affect the valuation of a pre-revenue startup:
- Traction – Since a startup does not have much to show in revenue, investors look for product adaptability. The more users, the better. Brownie points for lower cost of customer acquisitions. Needless to say, a dynamic cost-effective marketing strategy is important at this stage. Investors are more likely to fund if they are convinced about the startup’s growth potential on a limited budget. It simply indicates a higher ROI for the investor. Hence, a viable, scalable, cost-effective business idea increases the startup valuation.
- Reliable founders – The startup founding team is the face of the company. The merit of the product/service aside, investors look for an experienced founding team with diverse skill sets equipped to holistically grow the company. For instance, a tech startup with a promising patent will need strong marketing inputs to create a brand out of it. Similarly, founders with prior entrepreneurial experiences are an asset. Thus valuation for startups will be higher if they have a skilled, committed, and experienced founding team.
- Prototype – This is a game-changer. No matter how great a business idea is if the startup has managed to create a prototype with early adopters to show, their valuation increases considerably.
- Industry needs – Startup marketplace is presently dominated by AI and tech industries. This is where the money is. Investors tend to value a startup higher if they are catering to a profitable industry. Similarly, the demand for the product/service also matters. If there are more providers of the same product and lesser investors, the market will be highly competitive resulting in a lower valuation of a startup in this sector.
- Profit margins – Investors have a primary agenda – quick profits. Despite all the above four factors showing a high, unless the business as a whole promises a high-profit margin, the valuation of a startup will decrease.
Now that we have seen how the valuation of startups depends on its stage in the business lifecycle, in the next section we will discuss another aspect that is vital while evaluating any startup. Founders, and more importantly investors, have to be mindful of these criteria before deciding on their investments.
Pre-Money Valuation vs. Post-Money Valuation
Results from startup valuation methods sway investor decisions. An expert valuation indicates the investor’s equity percentage on funding a startup. In the initial stages, the returns will be small, but eventually when the startup goes public or is acquired, even the smallest equity percentage will fetch a massive return. For ease of calculations, startups are considered in two stages, pre-money and post-money.
What are the pre-money and post-money valuation of a startup?
Pre-money valuation is the value of a startup before the present round of funding, while the post-money valuation is the startup value after it will receive a fresh funding round. It is important to note that the post-money valuation shows an increased equity value of a startup, not its actual bank balance. The post-money valuation is comparatively easier to calculate as:
Post money valuation = Investment dollar amount /Percent investor receives
For example if the investment dollar amount is $2M and the investor’s demand is 10%, the post-money valuation for the startup will be $2M / 10% = $20M. However, the balance sheet will show an increase of $2M in cash.
Pre-money valuation = Post money valuation – Investment dollar amount
In continuation to the example above, the pre-money valuation in this case will be $20M – $2M = $18M
Further, to understand the per-share value at pre-money valuation:
Per-share value = Pre-money valuation / Total outstanding shares
As we see, apart from factors such as competitors, industry benchmarks, and scalability, investors will consider the pre-money and post-money valuation metrics as an important component of their various startup valuation methods discussed in brief in the next section.
Common Startup Valuation Methods
Despite several qualitative indicators, unless the startup reaches a mature stage in business, there is not much data available to base calculations on. Especially for a startup in the pre-revenue stage, a lot of it is estimated projections. However, here are some common startup valuation methods that come handy at different stages in the lifecycle of a startup.
Venture Capital Method
This is one of the methods to arrive at the pre-money valuation of a pre-revenue startup. In this startup valuation method, first the terminal value is estimated. Terminal value is the expected value of the startup during the harvest year, the year when the investor plans to exit. From this point, the pre-money valuation is calculated using the following formula:
Post money-valuation = Terminal value / Anticipated ROI
ROI = Terminal value / Post-money-valuation
Where Pre-money valuation = Post-money valuation – Investment
Scorecard Valuation Method
Otherwise known as the Bill Payne valuation method, this is a common valuation model for startups used by Angel investors for pre-revenue startups. The idea is to find the average valuation of all pre-revenue startups in the target company’s market and compare it to the pre-revenue valuation score of the target company.
Here is the scorecard with its corresponding value:
- Management team 0 – 30%
- Size of the opportunity 0 – 25%
- Product/Technology 0 – 15%
- Competitive environment 0 – 10%
- Marketing/Sales channels/ Partnerships 0 – 10%
- Need for additional investment 0 – 5%
- Others 0 – 5%
For example, if the target company’s score is x, the assigned factor for
- The management team will be 0.3*x.
- Size of opportunity will be 0.25*x
…and so on. The total score of the target company is the total of all the 7 factors. Finally, this value is compared with the average pre-money valuation of all pre-revenue companies in the target company’s industry.
This is quite a simple and straightforward startup valuation method. It involves choosing a reference metric from a similar company in the market and comparing the target company’s value with it. For example, if a competing business is valued at $2,000,000 and they have 100,000 early adopters of their prototype, this means that each prototype is valued at $20. Investors will use this as a benchmark to value the target company.
Risk Factor Summation Method
This valuation model for startups aims at risk assessment of the target pre-revenue startup. It is similar to the scorecard method and uses the following 12 elements to evaluate its risk status:
- Stage of business
- Funding/capital risk
- Manufacturing risk
- Technology risk
- Sales and Marketing risk
- Competition risk
- Legislation/political risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
The following values are assigned to each of these elements
- -2 ………….Very negative
- -1…………..Negative for scaling the startup and carrying out a successful exit
- 0 ……………Neutral
- +1………….Positive for scaling the startup and carrying out a successful exit
- +2………….Very positive
The pre-revenue startup valuation will increase
- By $250,000 for every +1
- By $500,000 for every +2
And the pre-revenue valuation will decrease
- By $250,000 for every -1
- By $500,000 for every -2
This startup valuation method as the name suggests is based on the idea that a company is worth only as much as it takes to duplicate it. This valuation tool considers only the tangible assets of a startup at the time of the valuation and estimates how much it would cost to replicate all of it.
The problem with this method is its myopic view of the startup’s real potential. It does not consider the intangible assets of a pre-revenue startup such as its brand, hotness of the industry, or its future market potential. Hence this method is only used as a lowball estimate of the business.
Discounted Cash Flow Method
This method of valuation for startups estimates the future cash flow of a pre-revenue startup. Based on this, the investor’s ROI is calculated. Furthermore, financial analysts apply high discount rates to neutralize the risk factors based on their assumptions about the business and emerging market trends. This is not a very reliable method as a lot of the projections are based on assumptions.
Valuation by Stage Method
This method addresses the basics of how startup valuation works. It is based on the business stage of the startup and provides a range of possible investments at each stage. Further along a company is in its lifecycle, the more stable it is, the lesser the risk of investments. Here is a brief of possible investments based on the company stage:
- Company value estimated – $250,000 – $500,000
- Promising business plan – $500,000 – $1M
- A promising business plan backed by a strong management team – $1M – $2M
- Has a prototype/viable technology/final product – $2M – $5M
- Has built strategic partners and built a strong customer base – $5M and above.
The Book Value Method
Otherwise known as the asset-based valuation method, this valuation model for startups considers only tangible assets of the company, similar to the cost-to-duplicate method. Since such valuations use statistics of the startup’s current status, it is mostly used to evaluate startups going out of business.