Every startup is aiming for a high valuation for their business. In business, valuation is the process of evaluating the present value of the asset in hand, in this case the overall value that a startup is worth. For startups, there are a variety of popular methods folks use to evaluate a business and determine its overall valuation. Different valuation methods are used for different reasons. To help break it down, we’ve outlined 10 popular methods for valuing startups.
Related Reading: Pre-money vs Post-money: Essential Startup Knowledge + 409a Valuation: Everything a Founder Needs to Know
1. The Berkus Method
Startups are risky. Less than 10% of startups make it past the first year of existence so determining the valuation of a startup, especially a brand new one with only months of lifespan can be extremely challenging. The Berkus Method is an attempted way to assess value without the traditional revenue metrics that many methods take into account for more mature organizations.
The Berkus Method quantifies value by assessing qualitative qualities instead of quantitative ones. Value is assessed in the Berkus Method with five main elements. The elements considered within the Berkus Method include value business model (base value), available prototype to assess the technology risk and viability, founding team members and their abilities or industry knowledge, strategic relationships within the space or team, existing customers or first sales that prove viability. A quantitative value can be tied to each relevant quantitative factor with the Berkus Method.
Source: Angel Capital Association
Pro Tip: When To Use This Method
The Berkus Method should be used pre-revenue. It can be a valuable valuation method when a new startup is formed with expert founders or former successful startup leaders at the helm or when a strong, viable product is in place. In these examples, there is enough qualitative information at hand to justify a quantitative value.
Related Resource: What is Pre-Revenue Funding?
2. Comparable Transactions Method
This valuation method at the highest level is essentially valuing the business based on what consumers would currently pay for it. This is one of the most conventional methods of valuation. To make a comparable transaction valuation, an investor or evaluator will look at companies of a similar size, revenue range, industry, and business model and see what they were valued at or sold for. This method is looking at validation from what others were willing to pay for similar companies in an acquisition or merger and use that to make a fair, or comparable, offer on the company seeking valuation.
Pro Tip: When To Use This Method
The most common scenario where the Comparable Transaction Method might be used is through a big M&A (Merger and Acquisition) deal.
3. Scorecard Valuation Method
When a company hasn’t produced any revenue yet, as an early-stage startup, it can be hard for investors to make a solid bet on the probability of their investments’ success. The Scorecard Valuation Method is one method that relies on the past investments of others taking similar bets and risks on pre-revenue startups. Similar to the comparable transaction method, the scorecard valuation method looks at similar startups or companies in the company at questions’ industry.
This valuation method looks at these similar companies and sees what types of valuation they received by other investors. From there, the median will be calculated from the value of all the similar companies’ valuations and this median will determine the average value of the target company. In addition to the median value placed on the competitive landscape, scorecards are looking at the strengths and weaknesses of the market as assessed by other investors and scoring their investment in question weighted with the following criteria compared to the other companies in the space:
- Board, entrepreneur, the management team – 25%
- Size of opportunity – 20%
- Technology/Product – 18%
- Marketing/Sales – 15%
- Need for additional financing – 10%
- Others – 10%
A company may be valued higher than the median with the scorecard method if the size of opportunity or board/management team is exceptional quality or vice versa, maybe docked if the tech is strong but the leadership is assessed as in-experienced.
Pro Tip: When To Use This Method
This method may be used by a startup that is in a crowded space such as marketing tech, sales tech, fintech etc.. and is pre-revenue; With a lot of similar or adjacent companies raising rounds and receiving valuations, a scorecard can be used successfully because there are is a lot of adjacent validation in the market.
4. Cost-to-Duplicate Approach
Startups are a risky investment for many reasons, but one big one is that it typically takes a lot of capital to run and scale a business and many startups struggle to manage their run rate and burn rate efficiently.
The Cost-to-Duplicate Approach to valuation considers all costs and expenses associated with the startup. The costs and expenses reviewed include the development of the product and the purchase of physical assets. A fair market value is then determined based upon all the expenses at hand. The negative of using this type of valuation approach is that it does not consider the future growth and potential of the company, only the current efficiency based on expense and it also doesn’t take into account intangible assets such as the talent of the leadership team, brand, patents, etc.
Pro Tip: When To Use This Method
The Cost-to-Duplicate Approach might be the right approach to asset valuation when the product is simple and won’t require a lot of expensive development, the team is lean and the burn rate of capital is extremely slow or even non-existent. Lean startups with one or two folks at the helm, or with a founding team that isn’t taking a salary yet could use this method to justify their first infusion of cash to start taking a salary or start making bigger financial moves.
5. Risk Factor Summation Method
Every venture capital fund or any investment firm is spending time unpacking the potential risks of each and every new investment they make. The Risk Factor Summation Method is used with risk as the primary method for evaluation. This approach values a startup by taking into quantitative consideration all risks associated with the business that can affect the return on investment.
An initial value is calculated (possibly even using one of the other methods discussed in this post) and then the risks are assessed, deducting or adding to the initial value calculation based on said risks to the return. Some of the different kinds of risks that are taken into account are management risk, political risk, manufacturing risk, market competition risk, investment and capital accumulation risk, technological risk, and legal environment risk.
Pro Tip: When To Use This Method
This method is often used by investors when looking at a new space or as a second pass on assessing the value of a potential investment.
6. Discounted Cash Flow Method
This method is predicting the valuation of a company based on its assumed future cash flows. The hope is that the DCF (Discounted Cash Flow) is above the current cost of investment resulting in projected positive return and higher valuation. A discount rate is used to find the value of present future cash flows.
For example, the discount rate might be the average rate of return that shareholders in the firm are expecting for the given year. That percent (maybe 5%, 10%, etc.) is then used to make a year-over-year assumption. This hypothetical informs investors that based on the current cash flow and discount rate chosen to asses, the expected cash flow can be anticipated from this investment.
Pro Tip: When To Use This Method
This is a great valuation method to use for a company that has relatively predictable and stable up and to the right growth up until the time of investment.
Related resource: Discounted Cash Flow (DCF) Analysis: The Purpose, Formula, and How it Works
7. Venture Capital Method
This method is one of the most common, if not the most common method used for evaluating startups that are pre-cash flow and seeking VC investment. The VC Method looks at 6 steps to determine valuation:
- Estimate the Investment Needed
- Forecast Startup Financials
- Determine the Timing of Exit (IPO, M&A, etc.)
- Calculate Multiple at Exit (based on comps)
- Discount to PV at the Desired Rate of Return
- Determine Valuation and Desired Ownership Stake
Its ultimately a quick, rough estimate informed by as much information as is available based on the market, comps, any existing quantitative and qualitative info from the company at hand, and an assumed amount of risk from the VC Firm.
Related Resource: A User-Friendly Guide on Convertible Debt
Pro Tip: When To Use This Method
Most startups should expect that this valuation method will be applied when seeking early rounds of funding, especially from popular venture capital funds.
8. Book Value Method
The Book Value of a company is the net difference between that company’s total assets and total liabilities. The idea of this valuation method is to reflect what total value of a company’s assets that shareholders of that company would walk away with if that company was completely liquidated. Book Value is equated to the carrying value on a balance sheet. To calculate book value, look at the total common stockholder’s equity minus the preferred stock and then divide that number by the number of common shares in a company.
Pro Tip: When To Use This Method
This valuation is extremely helpful in determining if a company’s current stock value is under or overpriced when attempting to determine overall valuation.
9. First Chicago Method
Named after the VC arm of The First Chicago Bank, this valuation method uses a combo of multiple-based valuation and discounted cash flow to make a valuation of a company. Essentially, this method allows you to take into account many different possible outcomes for the business into the valuation – to keep it simple, you can think of this method as taking into consideration the business’s best case scenario, worst-case scenario, and average scenario.
Looking at all 3 scenarios, an estimate is made as to how likely each scenario is. Next, you multiply the probabilities by their respected values and add them up. This gives you a weighted average valuation from the combo of the 3 most likely scenarios – valuing the business on the average of what will probably happen.
Pro Tip: When To Use This Method
This valuation method is recommended for dynamic, early-stage growth companies. It’s used when companies have a future with many possible outcomes that could come about based on the next decisions made.
10. Standard Earnings Multiple Method
A multiple is a fraction in which the top number (the numerator) is larger than the bottom number (the denominator). The earnings of a business are defined as income or profit. The Standard Earnings Multiple Method looks at the earnings of the business over an industry-standard multiple. Every industry and sector may have a slightly different average multiple.
Pro Tip: When To Use This Method
One common scenario where this method is used is to measure stock pierce earnings with price/earnings ratio, which measures stock price to earnings. P/E ratio tells what the market (stock buyers) are willing to pay for the company’s earnings with a higher ratio indicating that people are willing to pay more.
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