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When it comes to startups, how do you best determine their value? This is a question that plagues startup company owners, venture capital firms and angel investors alike. There are a variety of methods for startup valuation, but which one is the right one for your company? In this article, we’ll explore common startup valuation methods, explain how to value a startup, and help you choose the right method for your business.
What Is Startup Valuation?
Startup valuation is the process of determining the value of a new or early-stage company. This is important for a variety of reasons, such as appealing to angel investors, securing funding from a venture capital firm, or selling equity to employees.
There are a number of different methods that can be used to value a startup, and choosing the right method will depend on a number of factors, such as the stage of the company, the industry, and the financial situation. Pre-revenue startups, for example, will often be valued differently than companies that are already generating revenue.
Startup Valuation Methods
There are a number of different startup or pre-revenue valuation methods. Each has its own advantages and disadvantages, and choosing the right method will depend on the specific circumstances of the company.
Risk Factor Summation Method
The risk factor summation (RFS) method is a common pre-revenue startup valuation method. It’s often used for pre-revenue startups because it doesn’t require any financial information. This method assigns your company a base value by comparing it to another company similar to your own. Then, your company is assessed for 12 risk factors and that assigned value is determined based on the results.
The key risk factors that are typically considered include:
- Company Stage – Startups in the pre-revenue stage are generally considered to be at a higher level of risk than companies that are already generating revenue.
- Industry – Some industries are considered to be more high-risk than others. For example, biotech and pharmaceutical companies tend to be rated at a higher level of risk than companies in more established industries.
- Financial Situation – Startups that are already generating revenue are generally less risky than those that are not.
- Management Team – A strong management team can help reduce the risk of a startup.
- Competitive Landscape – If there are already many competitors in the market, it may be more difficult for a new startup to succeed.
The advantages of the RFS method are that it’s pretty straightforward and doesn’t require much financial data. The disadvantage of this method is that it’s very subjective. The values assigned to each risk factor can vary significantly from one person to the next.
Berkus Method
The Berkus method is another common pre-revenue startup valuation method to determine the value of startup ventures. It’s often used for pre-revenue startups because it’s based on the belief that the value of a company is based on its potential; not its actual performance.
This method assigns values based on five important factors:
- Sound Idea – Is the company’s product or service a good business idea?
- Quality Management Team – Does the company have a strong management team in place?
- Prototype – Does the company have a prototype or proof of concept that interests buyers?
- Strategic Relationships – Does the company have any strategic relationships in place, such as partnerships with other companies?
- Product Rollout or Sales – Does the company have a plan for how it will roll out its minimum viable product or service?
The advantages of this method are that it’s great for startups in very early stages and does not require complicated financial projections. The disadvantage is that it’s also very subjective and the values assigned to each factor can vary significantly.
Book Value Method
The Book Value method is a good option for companies that have been in business for a while and have a significant amount of assets. This method simply looks at the net worth of a company – meaning the total value of its assets minus the total value of its liabilities.
The advantage of this method is that it’s easy to calculate. The disadvantage is that it doesn’t take into account the company’s future potential or growth prospects.
Multiples Method
The multiples method is a popular startup valuation method because it’s relatively easy to use and it can be applied to companies at any stage of development. This method looks at comparable companies and applies a multiple to their revenue or earnings.
For example, if you’re trying to value a startup company that doesn’t have any revenue yet, you could look at similar companies that do have revenue and apply a multiple to their earnings. The most common multiples used are price-to-earnings (P/E) and price-to-sales (P/S).
The advantage of this method is that it’s relatively easy to use. The disadvantage is that it can be difficult to find comparable companies and the values assigned to each multiple can vary significantly.
Scorecard Method
The scorecard valuation method is a variation of the multiples method. With this method, you’ll create a scoreboard with different factors that are important to your startup company. Each factor is then given a weight, or importance, and a score.
For example, if you’re trying to value a tech startup focused on social media, one important factor might be the number of current users. Another important factor might be the engagement of those users. The company with the most users would get a higher score for that factor, while the company with the most engaged users would get a higher score for that factor. When all the scores are tallied, you’ll multiply each score by its weight to get a final valuation.
The advantage of this method is that it’s customizable and you can tailor it to your specific company. The disadvantage is that it’s another method where the scores assigned will vary from person to person.
Valuation By Stage Method
Valuation by stage is another good option for a startup company that is still in the early stages of development. This method assigns a value to a company based on its stage of development.
For example, a company that’s just an idea would be worth less than a company that has a prototype. A company with a prototype and some initial customers would be worth more than a company with a prototype alone. And, a company that’s generating revenue would be worth more than a company with initial customers, but without a prototype.
The advantage of this method is that it’s easy to use. The disadvantage is that it’s very subjective and there is a probable degree of variation on how much value each stage is given.
Cost-to Duplicate Method
The cost-to-duplicate approach is a good option for companies that have unique products or services. This method simply looks at how much it would cost to duplicate the company’s product or service.
For example, if you’re trying to value a software company, you would look at how much it would cost to develop the software from scratch. If you’re trying to value a restaurant, you would look at how much it would cost to build the restaurant, buy the equipment, and hire the staff.
The advantage of the cost-to-duplicate approach is that it’s easy to use. The disadvantage is that it doesn’t take into account the company’s potential or projected growth.
Venture Capital Method
The venture capital (VC) method is another common pre-money valuation strategy. This method is common for potential investors who might be looking to exit a startup after a set amount of time.
The VC method relies on two formulas:
Expected Return on Investment = Exit Value / Post-Money Valuation
Post-Money Valuation = Exit Value / Expected Return on Investment
Expected return on investment (ROI) is the amount of money that an investor expects to make from an investment. Exit value (sometimes called a terminal value) is the estimated value of the company at the time of exit, while post-money valuation is the value of the company after investment.
The advantages of this method are that it’s easy to understand and it can be used to value companies at any stage of development. The disadvantage is that it relies on a number of assumptions, such as future profits, projected revenue, the expected ROI and exit value, which can be difficult to estimate.
Discounted Cash Flow Method
The discounted cash flow (DCF) method is a popular startup valuation method that looks at the future cash flows of a company and discounts them back to present value. This method can be used for companies at any stage of development, but it’s especially useful for companies with a lot of projected future cash flows.
To calculate the DCF value of a company, you’ll first need to forecast the future cash flows for the company. This can be done using financial models or historical data. Once you have those projections, you’ll need to discount them back to present value using a discount rate. The discount rate is typically the weighted average cost of capital (WACC).
The advantage of the discounted cash flow method is that it takes into account the company’s future cash flows. The disadvantage is that it can be time-consuming to calculate and it relies on a number of subjective assumptions.
First Chicago Method
The First Chicago method is useful for companies where there are no comparable businesses in the same industry for comparison purposes or there is little data to calculate using other valuation methods.
This method requires calculating three different scenarios for your company: worst case, normal case, and best case. Your worst case scenario would be a situation where your company performs below expectations. The normal case, sometimes called base case, would be used if the company performs exactly as expected. Last, the best case scenario would be if your company exceeded all expectations.
Each of those cases is then assigned a value using either the DCF or VC methods (see above). Once those values are determined, each scenario is assigned a probability. This number is the percentage chance that each of those scenarios will actually happen. The final value is then determined by multiplying the DCF or VC values by the probabilities.
The advantages of this method are that it’s useful for companies where there is little data available. The disadvantage is that it can be time-consuming to calculate and it relies on a number of subjective assumptions.
Choosing a Valuation Method
These are just a few of the most popular startup valuation methods and there are several startup valuation methods you can still explore. Just remember that there’s no one “right” way of valuing startups. The best valuation method for your company will depend on a number of factors, including the stage of development, the industry, and the availability of data. One of the most important factors to take into account is whether you need a method for pre-revenue valuations or post-revenue valuations. You might also consider using more than one valuation method to get a more well-rounded picture of your company’s worth.
If you’re not sure which startup valuation methods to use, talk to a financial advisor who specializes in startup valuations or an investor. They’ll be able to help you choose the best valuation method (or methods) for your company.
