The valuation of a startup is one of the most important things to know when fundraising. It requires a fine balance to not undervalue or overvalue your venture. For a mature, publicly listed business with steady revenues and earnings, normally it's just a matter of valuing them as a multiple of their EBITDA or based on the industry-specific PE multiples.
Startup valuation is however never straightforward and one of the most complex tasks for any entrepreneur, especially for early-stage startups with little or no revenue.
In this article, we'll discuss what a startup valuation is, why it's important to estimate the value of a startup, and a few methods you can use to value your startup.
What is Startup Valuation?
Simply put, startup valuation is the process of quantifying the worth of a business. During funding rounds, investors fund a startup in exchange for a part of the equity in the business. Valuation is important for entrepreneurs as it helps in determining the equity portion, which they have to give away to an investor in exchange for their funds.
For an investor, the first step is to agree on the Pre-money valuation; i.e., what the startup is worth before the investment goes in, this can be best depicted as:
Post-money Valuation = Pre-money Valuation + Investment
Basis the example with a $250 K investment, you end up having a 25% stake in the company.
Why is it Important to Estimate a Startup's Valuation?
Investors would want to calculate their potential return on their investment (IRR).
Founders don't want to give away too much equity in return for funding, especially at the early stages.
How Startups are Valued?
Although there are many valuation methods that investors use to value a startup, in this article we'll cover 5 most commonly used early-stage startup valuation methods:
Venture Capitalists usually like this approach of comparable transactions, as it gives them a pretty good indication of what the market is willing to pay for a company. The comparable transactions method values a startup by determining how many other similar startups were acquired in recent years and uses that information as a precedent to arrive at an appropriate value range. This method may work best if you are comparing two startups offering similar products or comparable services. For more details, read here.
Dave Berkus Valuation Method
Berkus Method of Valuation is an early-stage valuation method that was explicitly created to find a starting point without relying upon the founder’s financial forecasts. The Berkus Method studies five crucial areas of a startup and indicates a value ranging from $0 to $500,000 for each area.
Risk-Factor Summation Method
Risk-Factor Summation (RFS) is a rough Pre-money valuation method for early-stage startups. In this method, you’ll evaluate a startup based on 12 risk factors (i.e. the stage of business, management risk, manufacturing risk, legislation/political risk, sales and marketing risk, funding and capital raising risk, competition risk, technology risk, litigation risk, international risk, reputation risk, and a potentially lucrative exit) to determine its Pre-money valuation.
Less risk, more value. High risk, less value. You will need to add/subtract ($0 to $500,000) from the bottom line based on those scores.
Valuation by Stage
Then there is the development stage valuation approach, often used by investors to quickly calculate a rough estimate of company value. Such "rule of thumb" values are typically set by the investors, based on the venture's current stage of development.
For example, a startup at the ideation (business plan) stage will likely get the lowest valuation, while once achieving some early traction can demand a higher value. The ranges might vary depending on the company and the investors.
Venture Capital Valuation Method
The Venture Capital Valuation methodology is simple and derived from the below equations:
ROI = Terminal value / Post-money Valuation, where Terminal value is the anticipated selling price for the startup in the future (i.e. usually 5 to 8 years for early-stage.) It can be estimated by establishing a reasonable expectation for revenues in the year of sale and, based on those revenues, estimating earnings in the year of the sale.
For example, we believe a startup could be acquired for $20 Mn in a few years, and we expect to receive a 10X return on our investment.
Using the formula, 10X = $ 20 Mn / Post-money Valuation
Post-money Valuation = $ 20 Mn / 10 = $ 2 Mn
Let's say we would like to invest $ 200K in this venture, the Pre-money Valuation = $ 2 Mn - $ 200K = $ 1.8 Mn, and the required equity stake would be 10% ($ 200K/$ 2 Mn)
Discounted Cash Flow (DCF) Method
This method relies on market analysis to make predictions about the company's future growth and how that may affect its overall profits. DCF involves forecasting how much cash flow the company will produce in the future (FCFF) 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.
Good practice suggests using the average of at least 3 valuation methods to estimate the appropriate Pre-money valuation for a startup.
Download this template to estimate the valuation of your startup!