Ultimate Guide to Startup Valuation
28 September, 2021
Over the years, the number of startups has been on the rise. More and more people are turning their ideas into products and services. A startup is a tiny business that began with such ideas and is looking for finance to mature and grow. These small businesses are still in the testing stages, in which they are working on building a team and testing their idea and product.
For them to raise money, they need to be valued. It is essential that, as entrepreneurs, you know and understand how the startup valuation process works.
Why is it essential to Value your Startup?
Startups generally only have a certain amount of capital; they can only develop their idea to a particular stage with a limited amount to spend. Without finance, the startup is destined to fail. As a startup owner, raising funds for the startup is as essential as developing the product.
Funds are essential for various things in a startup, such as marketing, prototype development, inventory, hiring employees, office space, and much more. Engaging in such activities is expensive, and startups cannot bear this cost. To attract funds, you will need to value your startup.
The investor's first question will be: How much is your startup worth? According to this, they decide how much they will be willing to invest in your startup.
Valuation Models for Startups
A valuation can be done in different ways depending on the industry and life of the business. Unlike mature companies, startups do not have tangible data to use to determine the business's value. Established businesses have statistics that support their investment, operations, and revenues, but on the other hand, startups do not have any of this data as they have not yet started selling their services. Performance data shows the stability of the company, making it easier for investors to analyze. However, startup valuations for a pre-revenue business do not have such data. To evaluate a pre-revenue business, you must comprehensively judge various factors determined by the market forces.
Investors and venture capitalists have many methods to value a startup; some are easy, and some are complex, each of which involves statistical analysis and qualitative variables. Here are some of the most common valuation models they use to value a startup:
#1 Scorecard Valuation
Also known as the Bill Payne valuation method, the scorecard valuation method compares the pre-revenue valuation score of the target startup to the average valuation of all the pre-revenue startups in the same industry. The scorecard will value different aspects of the startups by giving it weightage, such as
- Management - 0-35%
- Opportunity size 0-20%
- Technology 0-15%
- Competition 0-10%
- Partnerships, Marketing, and Sales channels 0-10%
- Funding requirement 0-5%
- Others 0-5%
#2 Venture Capital
In this method, a forecasted terminal value is employed for the startup and an expected investor return. It determines the pre and post-money valuations. The formula for this method is:
Pre-money valuation = post-money valuation - invested capital
The post-money valuation here is the terminal value divided between the expected return.
For example: if an investor values ABC startup at the terminal value of USD 500,000 and wants 10x the return on his USD 5,000 investment. The post-valuation, in this case, is USD 25,000 and the pre-valuation according to the venture capital method will be: USD 25,000 - USD 5,000 = USD 20,000
#3 DCF (Discounted Cash Flow)
In this method, financial analysts employ a technical tool to estimate the value of a startup by estimating the future cash flows. Then they are discounted at a given rate to determine the present value. The sum of the DCF will give the value of the startup. Additionally, high rates are applied to negate the risks based on the assumption about the company and the developing industry trends. This method is not best for valuing startups if they don't have forecasts and assumptions.
This method for valuing a startup requires heavy research as the main goal is to estimate the cost to start the company from scratch. This method is realistic and also shows the startups' competitive advantage. If the duplicating cost is low, the startup value will be close to nothing. But if it is expensive and the duplicating process is complex, then the startups' value will be high.
This approach considers data of similar transactions to help determine the value of the startup. For example, Another startup developed an app similar to yours, and a venture capital firm valued it at USD 2,500,000. The app has 50,000 users and subscribers currently. The venture capital firm valued the business at USD 50 per subscriber/user. Investors can use this benchmark to value your startup with a similar application.
Investors can use valuations by multiples method for startups that have sales and have recorded a profit. This is the most used method in cases where startups have sales. For example, your startup has an EBITDA of USD 500,000. Based on the industry you operate within, an investor can tell you that he is valuing your management at 10x, qualitative aspects at 15x, and competition at 5x your current EBITDA. This method is simple and powerful as it can determine a close to an accurate value for your mature startup.
Choose the Right Method for your Startups' Stage
There are different stages in a startup. It starts from the moment the idea was created until the business has matured and is fully operational. You will have to find out which stage your startup is in, and depending on this and the data available, you will choose the right method to evaluate it.
Investors Perspective The valuation of your startup is used to determine how much an investor is willing to invest. But there are other factors that an investor will consider before investing in your startup. Some of them are:
- An investor is more likely to invest in your startup if it is in a hot industry. Investors who are late to invest in a rapidly growing sector are likely to invest more as the market keeps growing - one such hot sector in the tech industry.
- If you have a good management team that is highly skilled and can make the best out of anything, then it can have a positive effect on the valuation.
- Investors like to see a functioning product or prototype of what you are offering if your startup is in the early stages.
Investors tend to invest low amounts or even choose not to invest in startups if:
The industry is commoditized. This means that there is a low margin of profit to be made in this industry.
- If the sector has poor performance
- If the sector your startup is in has a large number of competitors and low differentiation.
- Your management team is missing key persons
- You do not have a working product/prototype
- The startup burns through cash fast
Valuing your startup is an essential thing to do as it attracts investors. Moreover, you must do it right. Estimating the value of your startup through these methods will give you approximates of the value. No method will give you the perfect value for your startup, so it is essential to choose the right method depending on the stage you are in. Other factors will affect the valuation of your startup, as mentioned above. You can also value your startup. However, it is best to hire valuation professionals to do so as they will give you the closest accurate valuation for your startup.If you are looking to incorporate your business in the USA then contact IncParadise.
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