Startup Valuation 101: Definition, Methods and Calculations
Startup valuation is the key to attracting investors, making strategic decisions, and measuring the potential success of a venture. For founders seeking funding, investors aiming for promising opportunities, and analysts decoding the complex ecosystem, mastering the art of startup valuation is a must.
This comprehensive guide will explore the complex nature of startup valuation, its importance, influencing factors, and various calculation methods.
What Is Startup Valuation?
"How much is the new venture worth?" This question showcases the essence of startup valuation to some extent. It is a complicated process that aids in measuring the potential, capacity, and prospects of a newborn and evolving company.
Startup valuation specifies the dollar amount or price per share of equities of a recently established venture. This approach disregards the limitations of historical data and financial statements to envision the startup's growth trajectory in the dynamic landscape.
Unlike established companies with a previous track record, startups can't operate on traditional valuation techniques. With no operation history, revenue, and other objective data, entrepreneurs have to rely on methods that take into account the potential for future growth and analyze market dynamics.
However, this potential comes with risks and uncertainties as startups derive their value from future possibilities rather than past accomplishments. Serving like canvases that hold the potential to create revolutionary products and disrupt industries, startups operate in the waters of uncertainty and instability.
Why Is Startup Valuation Important?
For an entrepreneur, startup company valuation matters for various reasons. Accurate valuation affects financial outcomes and shapes the startup's success, relationships with investors, and overall strategic direction. It empowers founders and investors to make informed decisions that align with the actual startup's potential.
Here's a detailed summary of why determining startup value matters.
Startups often rely on external funding to support and accelerate their consecutive growth and development. Accurate valuation helps entrepreneurs determine how much equity to offer investors in exchange for the given funding amount while pitching to investors. Overvaluing or undervaluing the startup can lead to adverse terms or hinder the ability to attract necessary private and VC capital.
Improved Relationships with Investors
A well-supported and reasonable valuation does wonders for investor trust and confidence in the startup's prosperity potential. Conversely, misaligned valuations can lead to skepticism and strained relationships. That's why it's vital to ensure that data is realistic and relevant during pitch deck creation.
Fair Equity Allocation
Co-founders and early employees often expect initial work compensation with startup equity. A well-calculated valuation ensures that equity distribution is fair and aligns with the individual contributions of each stakeholder. Incorrect valuation can result in dissatisfaction and misalignment of expectations among team members.
Preparing for Acquisitions
In the case of acquisition prospects, businesses assess a startup's value as part of their due diligence process. An accurately valued startup helps negotiations proceed more efficiently and increases the likelihood of beneficial acquisition terms.
Regular assessment of the startup value against previous indications provides insights into the actual state and helps estimate the efficiency of strategic initiatives. That's why startup analytics plays an integral role in the company's and product's growth.
Attracting the Best Talent
A startup's valuation can also impact its ability to attract top talent. Skilled professionals considering joining the company often find a higher valuation appealing, as it indicates the potential for success.
Factors Influencing Startup Value
Startup valuation usually takes into account a manifold of factors that contribute to the company's potential brick-by-brick.
1. Growth Potential
One of the defining characteristics of startups is their unique progress rate, signaling their startup scaling potential. Investors know how to value a startup by considering the current situation and the room for development and improvement over time. That is because investors and VCs tend to value a startup company by assessing how rapidly it can scale, transforming an innovative idea into a flourishing business.
2. Place on the Target Market
As a new entity, your startup can enter the existing market with disruptive ideas or offer a unique advantage to address unmet needs. On the other hand, it can get started with a generic concept that resembles competitor's solutions in a crowded market. The evaluation looks at whether the startup occupies a unique position, brings a novice business model to the existing market, or can create a new market with paying audiences.
Startups entering the game of dense competition in ripe industries are more likely to attract investments of large scope. A quick look at the most promising industries to start a business suggests that there are ample opportunities for long-term success.
Domains like e-commerce, healthcare, transportation, and others, are actively booming these days and are some of the hottest industries that the majority of investors are looking at. Statistics suggest that the smart transportation market alone is expected to reach over 381 billion USD by 2032. Plus, according to recent findings, the compound annual growth rate prognosis states that the e-commerce sector will globally expand by 2027.
4. Intellectual Property
Patents, trademarks, copyrights, and proprietary technology are the building blocks of a startup's competitive advantage. Investors will likely bet more on those who have taken care of these intangible assets when starting a startup. This way, you can secure new offerings and distinguish your startup on the market.
5. Funding Stage
The startup's current funding stage and the amount of capital it has so far raised directly impact its valuation. A lot depends on the stages of startup development. Early-stage startups typically have higher risk factors, influencing their attractiveness to the investment community. As startups progress through later funding stages, their valuation can grow accordingly as they achieve milestones and reduce risks for investors and VCs.
6. Management Team's Quality
The founding team's skills, experience, and track record play a crucial role in startup valuation. A team with a history of successful ventures is more likely to cumulate investor confidence. Investors look into the startup team structure and assess the team's ability to execute the business plan and navigate challenges efficiently.
7. Revenue Model
The clarity and scalability of the startup's revenue model contribute to its favorable valuation. Investors often view subscription-based or recurring revenue models favorably because they offer the potential for consistent and predictable income.
Benchmarks and product performance metrics such as monthly active users, revenue growth rate, and customer retention rate play a crucial role in evaluating a startup's traction. An ideal candidate for high valuations is a startup with a proven track record of customer adoption, revenue growth, and user engagement. Such a profile is less risky and, therefore, more valuable in the eyes of interested parties willing to pour substantial sums of funding.
How to Calculate Startup Valuation
Startup valuation is not an exact science with formal rules dominating the calculations. Instead, some investors and stakeholders consider the general impression of the product and the team or assess the market size based on the current data.
However, different startup valuation methods help arrive at a reasonable estimate. Some common approaches suggesting how to calculate the valuation of a startup in a pre-revenue stage include the Berkus and Scorecard methods.
The Berkus Method
This is a structured approach to valuing pre-revenue startups based on key drivers that contribute to projected success. These drivers encompass the business idea, prototype, strategic relationships in place, executive team, technology, and product or MVP launch plans.
The Berkus method begins with the assumption that the startup will earn $20 million in revenue within the first five years. To evaluate the feasibility of this projection, an investor allocates funds, up to $500,000, across the above value drivers.
Each value driver represents an opportunity for the startup to reach its revenue goal. For instance, a potential estimation might look as follows:
Business Idea: $300,000
Strategic Relationships: $500,000
Management Team: $400,000
Rolled Out Product: $300,000
The calculation would include: 0.3+0.5+0.4+0.3+0.5 = $2.0 million
In this scenario, the startup valuation would amount to $2.0 million. However, the Berkus method expects a startup to hit a $20 million valuation in 5 years. Therefore, the next step involves assessing the capacity of the discussed value drivers to propel the startup's worth to the desired target.
To calculate the valuation of a startup using the Scorecard method, determining the average pre-money valuation of comparable businesses is a first step. Sources like Crunchbase or Pitchbook provide the required data about funding rounds, mergers, and acquisitions.
Say you've browsed the mentioned listings and found that a startup in your industry or market range raised 3$ million. Next, you need to decompose various aspects of this startup and compare them to your venture:
- scope of business opportunity;
- team's proficiency;
- competitive landscape;
- marketing and sales channels;
- investment requirements.
After that, you need to assign weights to each aspect when calculating valuation for startups:
- scope of business opportunity - (0-25% range);
- team - (0-30% range);
- technology - (0-15% range);
- competitive landscape - (0-10% range);
- marketing and sales channels - (0-10% range);
- investment requirements - (0-5% range).
Moving forward in this valuation method for startups, you'll attribute a target company impact (expressed as a percentage) to each parameter. Then, calculate the factor strength by multiplying each parameter by the corresponding target company impact. See the table below to have a glance at the required data:
Lastly, you multiply the overall score by your initial valuation estimate. In this instance, the total score amounts to 0.93. When multiplied by the base valuation of $3 million, we reach a valuation of $2.79 million.
Market Multiple Method
For companies that have gone past a pre-revenue stage, other approaches come in handy. Let’s find out how to determine the valuation of a startup that has a track record of earning revenue.
Such startups have a lot of hard data and financial metrics that investors and stakeholders can use and process in their calculations:
- total earnings;
- sales growth;
- EBITDA (earnings before interest, taxes, depreciation, and amortization);
- churn rate;
- customer lifetime value, etc.
The Market Multiple Method is a common approach to identifying the value of revenue-generating startups. It looks at publicly traded companies that are close to your startup based on factors like industry, scope, investment stage, and business model. This valuation startup method relies on the assumption that startups with similar characteristics should have similar valuations, providing a benchmark for comparison.
Say we're valuing a startup with an EBITDA of $1 million. We have identified an akin publicly traded technology company (Company X) with an Enterprise Value(EV)/EBITDA ratio of 12. The calculation will look in the following way:
- Valuation = EBITDA * EV/EBITDA Ratio = $1 million * 12 = $12 million
Using the EV/EBITDA ratio from the considered company, the valuation of your startup would be approximately $12 million.
Startup Valuation Methods
"How are startups valued?" is a question that leads to employing various valuation methods and approaches by investors and stakeholders. Every technique has specific advantages and limitations applicable to a particular company type. Variables like the startup's development stage, industry peculiarities, and prevailing market conditions affect the choice of the right approach.
Below, we'll overview some of the common methods used for startup valuation.
Venture Capital Method
This method provides an answer on how to valuate a startup and take into account investor-specific factors at the same time. The Venture Capital approach considers projected cash flows, potential exit scenario (acquisition or initial public offering (IPO), and associated risk factors for investors.
It estimates the startup's value based on pre-money valuation, the desired exit valuation, and the expected ROI. The formulas for this kind of valuation include:
- Post-money valuation = Terminal value / Anticipated ROI
- ROI = Terminal value / Post-money valuation
- Pre-money valuation = Post-money valuation – Investment
Discounted Cash Flow Analysis
This method determines how to value a startup company based on the future cash flow, anticipated growth rate, and underlying risks for investors. It is worth mentioning that projections rely heavily on assumptions.
First, the estimation of the discount rate, which represents the rate of return on investment, is necessary. Since startups are mostly newly established companies accompanied by elevated investment risk, it's common practice to apply a high discount rate. Subsequently, you discount the future free cash flow back to its present value.
Risk Factor Summation Approach
This method offers a comprehensive way to come up with accurate tech startup valuation. However, it would be best to use this approach on top of the initial valuation derived from one of the other methods discussed earlier. Here's why.
For example, once you've determined the average pre-money valuation of similar startups, you can quantify the risk associated with the startup and adjust the valuation accordingly. In this scenario, lower risk leads to a higher valuation. Investors can evaluate factors such as market, competition, technology risks, and management team quality to determine the overall level of risk associated with the startup.
This approach calculates all expenditures linked to the from-scratch development of products or services to arrive at a startup valuation. Cost estimations will include objective elements like recruitment, salaries, product implementation, inventory, office rent, etc.
The method excludes intangible assets such as brand value, team quality, and the overall potential for future growth. Consequently, the cost-to-duplicate approach generally generates lower startup valuations. Its major drawback is an underestimation of the venture's worth, especially for companies developing innovative solutions.
It's important to note that each valuation method has its strengths and limitations. Entrepreneurs and investors often use a combination of methods to arrive at a more comprehensive valuation estimate. Additionally, the ultimate choice can vary based on the stage of the startup, industry dynamics, and the availability of relevant data.
Final Thoughts on Startup Valuation
In this guide, we explored the intricacies of startup valuation and focused on why this activity is instrumental for entrepreneurs and investors. We enumerated aspects affecting startup worth and described methods employed to arrive at an accurate valuation result.
Now that you know how to determine startup valuation, you can better understand your startup's prospects. Equipped with this knowledge, you can gain the required edge and make a difference between a successful venture and a company that needs to catch up to its potential.
And if you're searching for a trustworthy tech partner who can assist you with your product, Upsilon has extensive experience in MVP development services and provides expert tech due diligence services, too. So, feel free to contact us to discuss your needs!