Valuation (Startup Valuation)

What is a Startup Valuation?

A startup valuation is the process of determining the value of a new and growing company, typically in its early stages. Valuations are often based on several factors, such as the company's potential for future growth, its revenue and profits, its intellectual property, and the experience and skills of its management team.

How do you calculate valuation of a startup?

There are several ways to calculate a startup’s value. However, they all have pros and cons, as valuating a startup is an incredibly difficult task, often referred to as more of an art than a science. A few of the most prominent methods used by venture capitalists and other investment groups include: 

• Cost-to-Duplicate: This approach involves calculating how much it would cost to build another company just like the original from scratch. The idea is that investors wouldn't pay more than it would cost to duplicate. This method prioritizes physical assets to determine a fair market value. While this approach is attractive because its fairly objective, its biggest drawback is that it doesn't reflect a company's future potential for sales and profit.  
• Market Multiple: This approach values a startup against recent acquisitions of similar startups in the market. The market multiple method arguably delivers value estimates closest to what investors are willing to pay. Unfortunately, comparable market transactions can be hard to find, and deal terms are often kept under wraps.
• Valuation by Stage: This approach, often used by angel investors and venture capital firms, is best for quickly producing an estimated range of a company's value. These "rule of thumb" values are typically set by investors, depending on which commercial development stage the startup is in. A valuation-by-stage model might look something like this:

What Will Get A Startup A Good Valuation?

There are many factors that can positively affect your startup’s valuation. Some of the most important include: 

• Traction: One of the best ways to improve your valuation is to show that your company has customers.
  Reputation: If a startup owner has a track record of coming up with good ideas or running successful businesses, this could result in a higher valuation.
• Prototype: Having a prototype that displays your product or service will likely help your valuation.
• Revenue: Since many startups seek valuations before establishing revenue streams, already having earnings coming in will help your case.
• Supply and Demand: More business owners seeking money than investors willing to invest could affect your business valuation.
• Distribution Channel: Where and how a company sells its product is important. If you get a good distribution channel, the value of your startup will likely increase.
• Industry Appeal: If a particular industry is popular and on the upswing, investors are more likely to pay a premium for the opportunity to invest. 

What will reduce a startup’s valuation?

Investors will be less likely to give your startup an ideal valuation if your company faces any of these factors: 

• Poor Industry: If your startup is in an industry that has recently performed poorly, that won't bode well for your valuation.
• Low Margins: Investors tend to be less interested in industries or products that have low margins.
• Competition: It could be difficult to convince investors your startup is worthy of a premium valuation if it's in an industry sector saturated with competition.
• Management Team Issues: Investors don't want to see management teams with either a poor or nonexistent track record.
• Product Issues: It will be an uphill battle with investors if your product doesn't work, lacks traction, or seems like a bad idea.
• Desperation: If you are seeking investment purely because you're almost out of cash, don't expect a high valuation. 

How much is a business worth with $1 million in sales?

Remember, a business is worth whatever someone is willing to pay for it. While valuations can be highly speculative — 40x or even 100x a startup's revenue — a general rule of thumb is to use a 10x multiplier. With that in mind, a reasonable valuation for a business doing $1 million in annual sales (and growing or preferably recurring) would be $10 million.

How do you value a startup that is pre-revenue?

Determining the value of a pre-revenue startup is quite the task. However, over the years, several methods have been developed, including: 

The Berkus Method: This method involves assigning a value to each milestone the startup achieves, such as completing a prototype, securing a partnership, or receiving a patent. The value assigned to each milestone typically ranges from $0 to $500,000, depending on the milestone's significance. The assigned values then get added together to arrive at a total valuation. 

• Scorecard Method: The method involves assigning startup’s a score based on factors such as the strength of the founding team, the potential market size, the level of competition, the strength of the intellectual property, and the stage of development. Each factor is assigned a weight based on its relative importance, and a score is assigned to each factor. The scores are then multiplied by their respective weights and added together to arrive at a total score. The total score is then used to arrive at a valuation range based on historical data of similar companies.
• Venture Capital Method: This method involves projecting the future cash flows of the startup over five to seven years, typically based on assumptions about revenue growth and profit margins. The projected cash flows are then discounted back to their present value using a discount rate that reflects the perceived level of risk associated with the investment. The terminal value of the startup, which represents the expected value at the end of the projection period, is also calculated and added to the present value of the projected cash flows. The sum of the discounted cash flows and the terminal value represents the estimated value of the startup.
• Risk Factor Summation Method: The method involves identifying and evaluating different risk factors, such as market risk, technology risk, and competition risk, and assigning a score to each risk factor based on its perceived level of risk. After adding the scores, the total score gets multiplied by a predetermined risk factor score multiplier. The resulting product represents the estimated value of the startup. In many ways, this method combines aspects of the Berkus and Scorecard methods.
• Combo Platter Method: The method involves selecting two or more valuation methods (e.g., Berkus, Discounted Cash Flow, Risk Summation, etc.) and weighting each based on its perceived relevance and reliability for the specific startup receiving a valuation. The results of each valuation method are then averaged or otherwise combined to arrive at a final valuation estimate.
• Asset-Based Method: The method involves identifying and valuing the company's tangible assets, such as equipment, inventory, and property, as well as its intangible assets, such as intellectual property, patents, and trademarks. The value of the company's liabilities, such as debts and other obligations, is subtracted from the total value of the assets to arrive at a net asset value. This net asset value represents the estimated value of the startup. 

How to do DCF valuation for a startup?

For most startups — especially those that have yet to generate earnings — their value largely rests on future potential. As you can imagine, that poses a challenge for assigning a valuation. Discounted cash flow (DCF) addresses that problem by forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth. A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows.