A startup company is a new business that is potentially fast growing and aims to fill a hole in the marketplace by developing and offering a new and unique product, process, or service but is still overcoming problems.
Startup valuation methods are the ways in which a startup business owner can work out the value of their company.
Positive factors determining startup valuation:
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.
Methods used:
1. Venture Capital Method- As its name indicates, the Venture Capital Method stands from the viewpoint of the investor. The valuation is a 2-step process:
- We want to derive the terminal value of the business in the harvest year.
- We work backwards using our (desired) ROI and investment amount to derive the pre-money valuation.
Calculating terminal value:
We need the following inputs:
- Projected revenue in harvest year
- Projected (or industry average) profit margin in harvest year
- Industry P/E ratio
Terminal Value = projected revenue * projected margin * P/E
Terminal Value = earnings * P/E
Example: Suppose a software company projects to generate $20M in revenue in 5 years (harvest year). It projects to have a profit margin of 10%. The industry P/E ratio is 25. Therefore, the terminal value = $20M * 10% * 25 = $50M
Calculating the pre-money valuation:
We need the following inputs:
- Required return on investment (ROI)
- Investment amount
Pre-Money Valuation = Terminal value / ROI – Investment amount
Example: Suppose the investor requires a return of investment of 20X. He plans to invest $1.5M.
Pre-Money Valuation = $50M / 20 – $1.5M = $1M
Finally, we have arrived at the current value of the startup before any investment has been made. The current value is $1M.
Using an investment of $1.5M, some assumptions on the growth projections and industry PE ratio, the company will be worth $50M.
The Venture Capital Method is meant for pre- and post-revenue startups.
2. Scorecard Valuation Method- The Scorecard Valuation Method uses the average pre-money valuation of other seed/startup businesses in the area, and then judges the startup that needs valuing against them using a scorecard in order to get an accurate valuation.
The first step is to find out the average pre-money valuation of pre-revenue companies in the region and business sector of the target startup: It may be possible to get this information from the Angel Capital Association with some investigation. Pre-money valuation varies with the economy and with the competitive environment for startup ventures within a region. In most regions, the pre-money valuation does not vary significantly from one business sector to another.
The next step is to find out the pre-money valuation of pre-revenue companies using the Scorecard Method to compare. The scorecard is as follows,
- Strength of the Management Team – 0-30 percent
- Size of the Opportunity – 0-25 percent
- Product/Technology – 0-15 percent
- Competitive Environment – 0-10 percent
- Marketing/Sales Channels/Partnerships – 0-10 percent
- Need For Additional Investment – 0-5 percent
- Other – 0-5 percent
The next step is to assign a factor to each of the above qualities based on the target startup. Let’s surmise that the company is in a sector that usually has a strong team background, but the company surpasses the sector in product technology. In this case we will assign 100% comparison to strong team background, and 150% to product technology.
The final step is to multiply the sum of factors by the average pre-money valuation of pre-revenue companies.
3. Risk Factor Summation Method- The Risk Factor Summation Method compares 12 elements of the target startup to what could be expected in a fundable and possibly profitable seed/startup using the same average pre-money valuation of pre-revenue startups in the area as the Scorecard method. The 12 elements are:
- Management
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each element is assessed as follows:
- +2 - very positive for growing the company and executing a wonderful exit
- +1 - positive
- - neutral
- -1 - negative for growing the company and executing a wonderful exit
- -2 - very negative
The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2).
4. Cost-to-Duplicate Method- As the name implies, this approach involves calculating how much it would cost to build another company just like it from scratch. The idea is that a smart investor wouldn't pay more than it would cost to duplicate. This approach will often look at the physical assets to determine their fair market value.
The cost-to-duplicate a software business, for instance, might be figured as the total cost of programming time that is gone into designing its software. For a high-technology start-up, it could be the costs to date of research and development, patent protection, prototype development. The cost-to-duplicate approach is often seen as a starting point for valuing startups, since it is fairly objective. After all, it is based on verifiable, historic expense records.
5. The Book Value Method- The book value method is also known as Asset-based valuation method. Out of all the methods described, asset–based valuation may provide the easiest way for investors to get a hard look at what a startup is currently worth in real value.
In asset valuation, the original cost of all assets is adjusted by impairment costs and depreciation. The total physical asset values are added to any balance sheet values–cash on hand, accounts receivables, and other positive balance sheet items. Liabilities–outstanding debts or expenses–are subtracted from the total to get the asset–based valuation.
6. Discounted Cash Flow Method- For most startups – especially those that have yet to start generating earnings – the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach. DCF involves 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.
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