How to Calculate a Startup Valuation?

Table of Contents:

  1. Comparable Transactions

  2. Dave Berkus Valuation Method

  3. Risk-Factor Summation Method

  4. Valuation by Stage

  5. Venture Capital Valuation Method

  6. Discounted Cash Flow (DCF) Method


For a mature, publicly listed business with steady revenues and earnings, valuation is just a matter of valuing them as a multiple of their EBITDA and/or based on the industry-specific PE multiples. To fully understand financial terms, read here.


Startup valuation is however never straightforward and one of the most complex tasks for entrepreneurs. Unsurprisingly most entrepreneurs struggle with "how to calculate their startup valuation?" This is more prominent for startups that have little to no revenue, where calculating a startup valuation is way too difficult.


In this article, we'll discuss first, why it's important to value a startup, what is a startup valuation, and 5 methods that you can use to value your startup.



Why is Valuation Important for Startups?


The valuation of a startup is one of the most important things to know when fundraising, as it helps determine the fair amount of equity they have to give to an investor in exchange for funds. It requires a fine balance so as to not undervalue or overvalue your startup.

  • 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.


PS: Does Valuing Your Startup Appears Complicated? Worry not, we can help!



What is Startup Valuation?

How to value a early-stage startup?

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 essential for entrepreneurs as it helps in determining the equity portion, which they have to give away to an investor in exchange for their funds.



Pre-money and Post-money Valuation


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 (by the Investor)

Basis the given example, with a $250K investment, the investor would end up having a 25% stake in the company.





How are Startups Valued?


Although there are many valuation methods that investors use to value a startup, in this article we'll cover the 6 most commonly used methods for calculating startup valuation!



a. Comparable Transactions


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.



b. Dave Berkus Valuation Method


The Berkus Method of Valuation is a prominent early-stage valuation method that was explicitly created to find a starting point without relying upon the founder’s financial forecasts. Berkus Method studies five crucial stages of a startup and indicates a value ranging from $0 to $500,000 for each stage.

Dave Berkus Valuation Method

c. 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.

Risk-Factor Summation Valuation Method

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.



d. 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.

Valuation by Stage

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.



e. 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)



f. 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. DCF analysis thus attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.


Discounted Cash Flow

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.



Summary


So to summarize:

  • Valuation is a highly complex task for ventures that have little to no revenue.

  • By valuing a startup, the founders determine the fair amount of equity they've to give to the investor in exchange for their funds.

  • Post-money Valuation = Pre-money Valuation + Investment.

  • There are 6 commonly used methods for calculating startup valuation:

  1. VCs often use the Comparable Transactions approach to get a pretty fair indication of what the market is willing to pay for a company.

  2. Dave Berkus is a prominent early-stage valuation method that uses a value (ranging from $0 to $500K) for each of the 5 crucial stages of a startup to arrive at a rough valuation.

  3. Risk-Factor Summation (RFS) is a rough Pre-money valuation method for the early-stage startups.

  4. The Valuation by Stage approach is often used by the investors to quickly calculate a rough estimate of company value.

  5. The Venture Capital Valuation methodology is simple and derived from the equation: ROI = Terminal value / Post-money Valuation, where Terminal value is the anticipated selling price for the startup in the future

  6. Discounted Cash Flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows.

  • A good practice is to use the average of at least 3 valuation methods to estimate the appropriate Pre-money valuation for a startup.


 

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