Startup Valuations

Startups face the challenge of determining their value since they often lack revenue figures or hard facts. Thus, estimation is required, and startup valuation methods frameworks have been invented to help startups accurately gauge their valuation. Startup founders aim for high valuation while investors want the value low enough to see big returns on their investment. This article will discuss the factors that determine startup valuation, negative and positive. Additionally, it will cover startup valuation methods such as the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), Discounted Cash Flow (DCF) Method, Venture Capital Method amongst others

1. FACTORS THAT DETERMINE STARTUP VALUATION

Positive Factors

• Traction – One of the biggest factors of proving a valuation is to show that your company has customers. If you have 100,000 customers you have a good shot at raising $1 million.
• Reputation – If a startup owner has a track record of coming up with good ideas or running successful businesses, or the product, procedure or service already has a good reputation a startup is more likely to get a higher valuation, even if there isn't traction.
• Prototype – Any prototype that a business may have that displays the product/service will help.
• Revenues – More important to business to business startups rather than consumer startups but revenue streams like charging users will make a company easier to value.
• Supply and Demand – If there are more business owners seeking money than investors willing to invest, this could affect your business valuation. This also includes a business owner's desperation to secure an investment, and an investors willingness to pay a premium.
• Distribution Channel – Where a startup sells its product is important, if you get a good distribution channel the value of a startup will be more likely to be higher.
• Industry Trends – If a particular industry is booming or popular (like mobile gaming) investors are more likely to pay a premium, meaning your startup will be worth more if it falls in the right industry.

Negative Factors

• Poor Industry or Market – If a startup is in an industry that has recently shown poor performance, or may be dying off.
• Low Margins – Some startups will be in industries, or sell products that have low-margins, making an investment less desirable.
• Competition – Some industry sectors have a lot of competition, or other business that have cornered the market. A startup that might be competing in a cluttered market is likely to put off investors.
• Management Not Up To Scratch – If the management team of a startup has no track record or reputation, or key positions are missing.
• Product – If the product doesn't work, or has no traction and doesn't seem to be popular or if there isn’t a product-market fit.
• Desperation – If the business owner is seeking investment because they are close to running out of cash.

2. STARTUP VALUATION METHODS

Early-stage startups usually have little to no revenue or profits; therefore, valuing them can be challenging. Angel investors and venture capital firms use multiple formulas to find the pre-money value of a business. With mature businesses that receive steady revenue and earnings and make profits, it is easier to value the company using 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.

1. Venture Capital Method

The Venture Capital Method employs a forecasted terminal value for the startup and an expected return from the investor to determine pre-money and post-money valuations. 

The formula used 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:

2. Berkus Method

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.

3. Discounted Cash Flow Method

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:

1. Your business performing exactly the way you expected.
2. Business performance being poor than what was expected.
3. Business performance is better than what was expected.

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.

4. Market Multiple Method

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.

CONCLUSION

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 how to evaluate and value a startup.

FAQs

1. How to calculate the valuation of a startup based on funding? 

The valuation of a startup based on funding is typically determined by the negotiation between the startup and the investor(s) during a funding round. The valuation is influenced by factors such as the startup's growth potential, market traction, team expertise, competition, and the terms of the investment. Generally, the valuation is based on the amount of funding raised and the percentage of equity or ownership stake given to the investors.

2. How to value a startup without revenue? 

Startups without revenue can be challenging to value since traditional financial metrics like revenue or profit may not be applicable. In such cases, valuation often relies on other factors such as the startup's market potential, intellectual property, growth prospects, team expertise, traction, user base, partnerships, and competitive advantage. Comparable valuations of similar startups in the industry or the use of valuation models like the discounted cash flow (DCF) method or the market approach can also be considered.

3. How to value a loss-making startup? 

Valuing a loss-making startup can be challenging since traditional financial metrics may not accurately reflect its potential. In such cases, valuation often relies on factors like market potential, intellectual property, team expertise, growth prospects, user base, partnerships, and competitive advantage. Investors may also consider the startup's ability to generate future revenue, cost management strategies, the market demand for the product or service, and the startup's progress in reaching key milestones.

4. How to calculate post-money valuation? 

Post-money valuation refers to the value of a startup after a new round of funding has been received. It can be calculated by adding the amount of funding raised in the latest round to the pre-money valuation. For example, if a startup has a pre-money valuation of $5 million and raises $2 million in a funding round, the post-money valuation would be $7 million ($5 million + $2 million).

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The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of statute, latest judicial pronouncements, circulars, clarifications, etc before acting based on the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.

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