Startup Valuations

21 March 2022


Startup valuation methods are the ways in which a startup business owner can work out the value of their company. These methods are important because more often than not startups are at a pre-revenue stage in their life-span so there aren't any hard facts or revenue figures to base the value of the business on.

Because of this guesswork, 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.

Business owners want the value to be as high as possible, whilst investors want the value to be low enough that they'll 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.

Methods of valuation

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 publicly listed 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).

EBITDA

EBITDA is best shown with the following formula - EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization

For example, if a company earns INR 1,000,000 in revenue and production costs of INR 400,000 with INR 200,000 in operating expenses, as well as a 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 you would add the INR 200,000 net profit to the tax and interest to get the operating income of INR 300,000 and add on the depreciation and amortization expense of INR 100,000 giving you a company valuation of INR 400,000.

Factors that determine Startup Value

  • 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.
  • Hotness of Industry – 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 – 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 this situation 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 a good idea.
  • Desperation – If the business owner is seeking investment because they are close to running out of cash.

Methods of valuation

Venture Capital Method

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:

Berkus Method

A straightforward method that values startups based on five key aspects, giving each aspect a certain amount of money

Qualitative element to be considered Value

Sound Idea

Prototype

High-Quality Management Team

Strategic Relationships

Product Rollout or Sales Made $500,000 each.

For each feature the startup possesses in full, the valuation should go up by $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 with no revenue generation, this might be an ideal way to arrive at the valuation.

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.

Conclusion

To conclude, Start-up valuation depends a lot on judgment and qualitative factors like Founders and Co-Founders background, experience and passion, Biz Model, Scalability potential of business (with or without technology), Competitive landscape, Current Traction. Startup's often operating 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.

Disclaimer:

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 on the basis of 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 Consulting 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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