Startup Valuation – 6 Best Practices Explained

Startup Valuation – 6 Best Practices Explained

Business valuation is never straightforward and there is no “one size fits all” approach. It is the analytical process of determining the current (or projected) worth of an asset or a company. There are many methods used for doing a business valuation and this applies the same to startup valuation. In fact, it can be quite a tricky endeavour to perform startup valuation. 

There are usually many factors to take into consideration – the management team, product demand, market trends and marketing risks involved. Here’s the hard reality: even after a proper evaluation of everything with the most effective valuation formula, the best you can hope for is still an estimate.  

Startup valuation methods are particularly important because they are applied to startup companies that are currently at pre-revenue stage and business owners will hope for a high valuation whereas investors will prefer a lower value that promises a higher return on investment (ROI). Unlike mature businesses, there are no financial records or steady stream of revenues to show potential growth and ease calculations of the startup valuation.

Venture capital firms and individual investors have several methods to perform startup valuation with a range of easy and complex ones that involve several qualitative and quantitative variables. 

These are 6 best practices:

startup

1. Venture Capital Method

This is a valuation that uses a forecasted terminal value for the startup and an expected return from the investor, often stated as 10X, 8X and so on. It is to determine the pre-money and post-money valuations. The calculation formula is as follows:

Pre-Money Valuation = Post-Money Valuation – Invested Capital 

With the Post-Money Valuation being the terminal value divided between the expected return.

Eg. An investor values your startup at a terminal value of $2,000,000 and he wants a 20X return on his $20,000 investment so it will be $2,000,000 divided by 20X and that will give you $100,000 for the Post-Money valuation. 

For Pre-Money Valuation, it will be $100,000 – $20,000 = $80,000

2. Cost To Duplicate Method

This method requires some due diligence as its main objective is to determine how much capital is needed to start the business from scratch. It is a very realistic approach that questions the competitive advantages. 

If the cost of duplicating the business is very low, then its value will be worth almost nothing. However, if it is costly and complex to replicate the business model, then the startup valuation will increase proportionately with the cost and complexity.

3. Berkus Method

This is a straightforward method that values startups based on five key aspects and giving each aspect a certain amount of money. The five qualitative aspects are sound idea, prototype, high quality management team, strategic relationships and product rollout or sales made $500,000 each. 

For each aspect possessed in full, the valuation should go up by $500,000. However, it depends on the extent in which each aspect is developed. The investor could possibly reduce the value of the item to $300,000 or $150,000, to determine the final value. 

4. Discounted Cash Flow Method

This method is a technical tool employed by financial analysts to determine the value of a business by estimating its future cash flows and discounting them at a certain discount rate to obtain their present value. 

The sum of the discounted cash flows will be the determined amount for the valuation and given the fact that this method relies on assumptions with the performance of some historical data, it is considerably not the most popular method used to do startup valuation.

5. Comparables Method

This method uses referential information and numbers from similar transactions to estimate the value of a startup. Eg. A similar app to the one developed by the startup was recently valued by a venture capital firm at $3,000,000 and the app had 100,000 active users. 

This means that the company was valued at $30 per user. An investor could use this as a benchmark to value a startup with a similar app. The comparables method provides an observable value hence it is the most widely used approach as it is easy to calculate and always current.

6. Valuation By Multiples Method

This is usually used on startups that have already started making money and are showing profits. Eg. It is generating an EBITDA of $300,000. Depending on the industry the startup is in, competition, management team and some other qualitative aspects, an investor could tell you he is valuing your business at 5X, 10X or 15X the current EBITDA. 

The EBITDA margins provide investors with a snapshot of the startup’s short term operational efficiency. As the margins ignore the impacts of non-operating factors such as taxes or intangible assets, the result is a more accurate reflection of the its operating profitability hence this method is used by investors to quickly estimate the value of a more mature startup. 

There are more methods but these are some of the most commonly used for startup valuation. There is no perfect method to value a business that is at the pre-revenue stage but it gives you an idea of what you could expect and ask for your startup. We hope this puts you in a better position when it comes to the funding stages. 

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