24 March 2023
Startup valuation methods are the ways in which a startup founder can work out the value of their company. These methods are important because more often than not startups are at a pre-revenue stage so there aren't any hard facts or revenue figures to base the value of the business on.
Because of this an estimation has to be used, which is why several startup valuation method frameworks have been invented to help a startup business more accurately gauge their valuation.
Founders want the value to be as high as possible, whilst investors want the value to be low enough so that they will see a big return on their investment.
Every startup would require enormous seed capital and funds to fuel the different stages of their growth. And just the greatness of their idea or the authenticity of their success won't lure out the investors. Though all these factors are important, it is ultimately the valuation of a particular startup that attracts the investors and venture capitalists to invest in them.
Hence, it becomes crucial to rightly predict their worth because anything less or more would leave a serious dent in their path of growth.
Having understood the significance of evaluating a startup, let's jump into the details of it.
Early stage Startups usually have little or no revenue or profits. But in the context of fundraising, your company is ultimately worth what you and your investors agree it's worth. Most angel investors and venture capital firms use multiple formulas to find the pre-money value of a business, or how much it’s worth before they invest. It’s fair to say that valuing a startup is both an art and a science.
Because of this reason it can be difficult to place a valuation on the company.
With mature businesses that receive steady revenue and earnings it is a lot easier. All you have to do is value the company as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA).
Concept of EBITDA
EBITDA is best shown with the following formula - EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization
For example, if a company earns INR 10,00,000 in revenue and production costs are INR 4,00,000 with INR 2,00,000 in operating expenses and depreciation and amortization expense of INR 100,000 that leaves an operating profit of INR 300,000. The interest expense is INR 50,000 leading to earnings before taxes of INR 250,000. With a 20 percent tax-rate the net income becomes INR 200,000.
For calculating EBITDA, add tax and interest to the net profit of INR 200,000 to get the operating income of INR 300,000 and also add on the depreciation and amortization expense of INR 100,000 giving you a Earning Before Interest Tax Depreciation and Amortisation of INR 400,000.
A startup valuation that employs a forecasted terminal value for the startup and an expected return from the investor (often stated as 10X, 8X, and so on), to determine pre-money and post-money valuations. The Venture Capital Method’s formula is:
Pre-Money Valuation = Post Money Valuation — Invested Capital
With the Post-Money Valuation being the terminal value divided between the expected return.
Let’s say an investor values your startup at a terminal value of $1,000,000 and he wants a 20X return on his $10,000 investment. In this case, your Post-Money valuation would be $50,000. And, according to the Venture Capital Method, the Pre-Money Valuation would be:
Pre-Money = $50,000 — $10,000 = $40,000
This is another popular method utilized by a lot of venture capital firms. To calculate the value of the firm, you will need to derive the terminal value or the value at which you will be selling the business and the Return On Investment. Plugging in these values to the formulas will help you arrive at the solution. The formulas for the same are as follows:
The Berkus Method, created by American venture capitalist and angel investor Dave Berkus is a straightforward method that values startups based on detailed assessment of five key aspects called as success factors :
Basic Value, Technology, Execution, Strategic Relationships and Production and Consequent Sales
A detailed assessment is carried out to evaluate how much monetary value is assigned to each aspect. The startup value is the sum of all those monetary values. This method usually allocates $500,000 per success factor so theoretically the maximum pre-money valuation is $2,500,000. Nevertheless, depending on the degree in which each element is developed the investor could reduce the value of the item to say $400,000 or $250,000, to determine the final value.
Though the Berkus Method is seen as an important method utilized by many startups, it fails to take into consideration a lot of other aspects of startup life. However, for a startup that is in the early stage of its life or in development stage with no revenue generation, this might be an ideal way to arrive at the valuation.
Startups and risk go hand in hand. When compared to a normal or running business, startups are riskier. That being said, for the amount of risk you take, you will expect the same level of reward. The same idea is behind this method.
Here, you will be required to calculate the future discounted cash flows which your business will be getting throughout the period or estimated period. To that, you will have to apply a discount rate or ROI to arrive at the right value.
Now, if you are getting a higher discount rate, that means your returns from the business should also be higher, and so, your valuation increases. There are three main scenarios under this method that will offer insights into your valuation. They are:
Here, the sum of discounted values will be your valuation. This method depends on both future and historical data to arrive at the solution.
Given the fact that this method relies heavily on assumptions that require some historical data to be performed, it is not the most widely employed to value startups.
A Market Multiple is calculated using recent acquisitions or transactions that are similar in nature to the company or startup in case on hand. The startup is then valued using the calculated Market Multiple.
To conclude, Start-up valuation depends a lot on judgment and qualitative factors like Founders and Co-Founders background, experience and passion, Business Model, Scalability potential of business (with or without technology), Competitive landscape, Current Traction. Startup's often operate in the valley of death which requires considering the probability of their success and failure. In a way, Start-up valuation also involves validation of the business model which makes it complicated vis-vis other valuations. As everything is future driven in start-up, the experience of valuer plays a significant role in value conclusion.
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