Startup Valuation 101: How Are Startups Valued?
Many valuable companies are reshaping industries and changing the lives of people. As a result of their potential to generate returns and impact society at large, they have been attracting investors to invest capital. A startup needs capital to become successful for its growth and expansion. Whereas, investors seek high-valued companies as they consider such companies as great opportunities to earn massive returns.
However, to lead up to this relationship, both the investors and startup founders need to agree on a fair value of the company. Determining a correct startup valuation is a critical point for both the startup and investors. That’s because it will lay the foundation of their relationship.
The challenge is that determining the value of a seed-stage startup is challenging. This is because a seed-stage startup typically lacks the metrics needed to determine valuation using traditional methods. On the other hand, VCs, business angels, and entrepreneurs use subjective methods to determine the value of a startup.
Therefore, in this article, we will discuss the valuation process of startups in different stages of their financing cycle. Plus, we will discuss the various startup valuation methods that will help investors determine how are startups valued?
But before we discuss various startup valuation methods, it is important to understand the startup’s financing cycle. That’s because the type of method to be used to value a startup will depend upon the stage of its financing cycle.
Startup Financing Cycle
A startup life cycle may consist of the pre-seed stage, seed stage, early-stage, mid-stage, and public market stage.
Source: Equity Zen
1. Pre-Seed Stage
At this stage, the company still has not developed any minimum viable product and does not have a validated business model. It just has a raw idea without development.
In fact, at this stage, the founding members seek validation of the idea from the potential customers.
So, to obtain funds, the founding members typically seek their relatives and friends. The uncertainty is high as the investors use their personal funds to invest in such startups.
2. Seed Stage
In the Seed Stage, the business idea comes true and the founders seek funds to expand the idea. This is the stage where the founding members aim to validate the business model and develop a minimum viable product. Such a product will enable the company to test the product in the market with real customers.
Thus, the Seed Stage includes companies that have carried out MVP already. Such companies are now looking for getting their business model and the product validated from the real market.
Typically, the seed-stage companies are funded by friends and family, business angels, and seed-stage venture capital funds.
3. Early Stage
This phase of the life cycle of a startup involves startups that seek to improve their product. Accordingly, at this stage, the startups are able to collect feedback from their customers. As a result, they are able to generate some metrics that help them to determine their product performance.
Using such data, the startups are able to correct their product failures. Also, they are able to convert the minimum viable product into a tangible product. Such a product is the one that is approved by the target market and hence easily scalable.
Consequently, early-stage startups seek funds from investors to grow their business model. Typically, angel investors and venture capital funds provide funds to the early-stage startups for funding their growth.
4. Growth Stage
In the growth stage, a startup typically focuses on enhancing its customer base and improving business profitability. It already has a market-validated product, repeat customers, and positive performance metrics. Besides this, a growth-stage startup has a well-defined growth strategy in place.
As a result, the key parameter to value growth-stage startups is cash flows. Both the size and stability of cash flows are important for such businesses to ensure external financing. Typically, venture capital funds are the key players who invest in growth-stage startups.
5. Expansion Stage
As the name suggests, the expansion stage is the one in which seeks to expand its customer base. Accordingly, it looks for expanding beyond its consolidated target market.
An easy way through which expansion-stage companies achieve this is through partnerships with large corporates. These corporates operate in different sectors and locations.
A crucial aspect of the companies seeking funds at this stage is that the uncertainty and the risk involve are huge. This means the consequences of a bad investment decision can be tragic.
Thus, obtaining funds through external sources becomes important for growth-stage companies. Since such companies require massive funds for their expansion, venture capital funds are the ones who invest in such businesses.
6. Exit Stage
Typically, a startup aims for a successful exit. Though, some founders aim to create a high-value and long-run company.
The two ways in which an exit can be carried out are Buyouts and IPOs.
Buyout refers to the sale of a startup to a huge corporate. Such a corporate is the one that operates in the same sector and aims to improve its market position through such a purchase. In fact, a corporate may seek to buy out a startup in order to exploit the complementary characteristics of both businesses.
Whereas, IPO refers to a company going public by selling its shares in the stock market.
Since we are clear with the various stages of the life cycle of a startup, let’s understand how do you value early-stage startups.
How are Startups Valued?
The valuation of a startup is important for an investor to determine. That’s because such a metric helps them in determining the fair economic value of their interest as an owner in the business.
So to estimate the fair economic value of an owner’s interest, the valuation of a startup must consider the current market value of the assets that the company has. Further, it should also consider the potential future performance the company can deliver to its owners.
Typically, companies use traditional methods of valuation. These company valuation methods focus on factors like generation of cash flows, earnings growth, capital structure, and other financial metrics. Such financial metrics are used to value a company, especially a mature company. Its because such metrics can be forecasted easily in the case of mature companies.
However, these traditional valuation methods cannot be used to value a startup having little or no historical financial data.
Thus, a mix of valuation methodologies based on the financing and operating stage of a startup are used to determine its valuation. The following chart summarises various valuation methods along a company’s typical financing cycle.
Valuation Models for Startups
The early-stage startups use the following non-traditional valuation methods.
1. Venture Capital Method
The Venture Capital Method of valuation is a method in which an investor determines the expected rate of return of investment that a target startup will generate on exit.
In other words, an investor first defines the selling price that he expects to receive after the holding period in this method. The holding period is typically three and seven years.
Once the expected selling price is determined, the investor then starts calculating backward the current startup valuation after receiving the funds. Typically, pre-revenue startups use the Venture Capital method to value their startups. That’s because it’s easier for such firms to estimate a potential exit value of their business after achieving certain milestones.
How to Calculate Valuation of a Startup Using Venture Capital Method?
As mentioned above, the first step to value a startup under this method is to estimate the expected selling price that an investor will receive on exit after the holding period.
To estimate the expected selling price, we first need to estimate certain future metrics. Such metrics are the ones that drive the exit value (terminal value ) of a startup. An investor can use multiples of comparable companies and similar past transactions from the related businesses.
Typically, EV/Revenue and earning ratio are the multiples that investors use to determine a target company’s Terminal Value. Once the startup calculates the terminal value at the time of exit, it needs to calculate its present value. To do so it needs a discount rate. Thus, the value so achieved is the value of the startup after receiving the funds.
It is important to note that this method determines the valuation of a startup from the point of view of the investor and not the startup founders. Thus, the discount rate that one needs to consider for valuation should not be the Weighted Average Cost of Capital (WACC) of the startup. But, the discount rate must be the expected Return on Investment (ROI) that the investor is looking for.
Post-Money Valuation = PV (Exit Value) = Terminal Value/Return On Investment (ROI)
After determining the post-money valuation of a startup, one needs to convert this into the pre-money valuation. This is done by subtracting the amount of money invested in the firm from the post-money valuation.
Pre-Money Valuation = Post-Money Valuation – Investment
Limitations of Venture Capital Method of Valuation
- One of the major disadvantages of the Venture Capital Method is that it is based on the assumption that there will be no issuance of equity in the startup in the future. This means that the ownership of the investor in the startup is the same at the beginning as well as at the end of the investment period. This is not a reasonable assumption because the main fuel with which a startup function is the issuance of equity.
- This method of valuation does not take into account certain payments that are made to an investor by the startup within the investment period. This is especially the case when the investor is a venture capital fund that is trying to minimize its risk.
- The multiples used to calculate the terminal value incorporate a certain level of uncertainty.
2. Berkus Method
Unlike other methods of valuation, the Berkus Method of Valuation does not consider financial metrics to determine the valuation of a startup. Instead, this method considers the operating risk of running a startup.
As per the Berkus Method, there are typically five important operating risks that determine whether a startup will succeed or not. These include the idea, prototype, team, strategic relationship, and sales.
a. Product Risk
The first operating risk of a startup is whether it has a sound idea as well as goals to reduce the basic value and the product risk. An investor can assess this risk by determining whether there exist similar products in the market. In case there are no similar products in the market, the investor can use his subjective judgment to value such a risk.
b. Technology Risk
The second operating risk of a startup is whether it has a prototype as well as goals to reduce the technology risk. Investors can measure this risk by assessing the prototype of the startup in which they intend to invest their funds. Besides this, they also need to consider the market reaction and customer opinion regarding the prototype.
c. Management Team Risk
The next operating risk of a startup is whether it has a quality management team as well as goals to reduce the execution risk. Investors can assess this risk by understanding whether the key people work as a team and are aligned with the firm’s objectives. They must also ensure that the team is well-diversified in terms of having people having expertise in different fields.
d. Strategic Relationships
The fourth operating risk for a startup is whether the firm has strategic relationships as well as goals to reduce the market risk and the competitive risk.
To assess this risk, the investor needs to analyze whether the startup has a team of advisors who are trustworthy. Besides this, the investors need to assess the investments already made in the startup and the ways of financing that the startup is preferring.
The fifth and last operating risk for a startup is whether it is able to make sales and has goals to reduce the financial and production risk. Investors can analyze such a risk by determining the traction that the product is getting once it is launched. Additionally, they also need to assess the response of customers towards the product.
After all the above five risks are assessed, the investors need to assign a value to each of the risks. The amount to be assigned to each of the risks depends upon the investor’s analysis as well as the industry in which the startup operates.
One thing that investors must remember using the Berkus method is that the startup valuation must not be so low that it allows investors to take extreme risks. In other words, the valuation of the startup should not be so low that it gives an opportunity to the investors to achieve ten times the value of their investment over its life.
Limitations of Berkus Method of Valuation
- One of the major disadvantages of the Berkus Method it can be used to value startups which the investors believe can reach over $20 million in revenues by the fifth year.
- Another limitation of this method is that it is very rigid while defining the operating risks of a startup.
- Also, the Berkus method of valuation is too subjective. This is because the rating of each of the risks is done by the investor intending to invest in the startup.
3. Scorecard Method
The renowned business angel Bill Payne developed the Scorecard method of valuation in the year 2010. This method of startup valuation is based on the concept that the investors must compare the startup in which they intend to invest with the other funded startups.
While comparing a startup with the other comparable startups, investors can adjust the startup valuation by taking into consideration different factors like geography or industry. However, the ideal scenario under the Scorecard Method of valuation is that all the comparable startups must share the same factors.
This method of valuation is typically used for pre-revenue startups, that is, startups that have not yet started generating revenues. Although, it can be used to value startups at different growth stages.
Thus, to value a startup under the scorecard Method, the first step that Payne considered was to determine the average pre-money valuation of similar or comparable startups. To come up with such numbers, Payne conducted a survey of the North-American startups. He published his ScorecardMethodology Worksheet with the business angels based on the survey results. The worksheet showcased that the North-American pre-revenue startups were valued between $1 million and $2 million, with the average assumed to be $1.5 million.
The next step that Payne considered was to define the seven relevant factors that may lead to the success of a startup. After defining the factors, he assigned weights to each of the factors. This way the investors valuing a startup can vary the previously mentioned weight within a certain range.
The following table showcases various success factors and the range of weights assigned to each of the factors.
|Strength of Entrepreneur and Team
|Size of the Opportunity
|Product or Technology
|Marketing, Sales, or Partnerships
|Need for Additional Investment
In the third step, the investors need to assign comparison factors to the relative weights. Now, to determine the relative weights for each of the comparison factors, the investors need to conduct an intensive market analysis.
Such an analysis will help the investors to analyze where the target company stands in comparison to its competitors.
For instance, the investors can assign a 100% comparison factor in case the size of an opportunity for the startup is in line with its peers. However, the investors will assign more than 100% comparison factor in case the size of the opportunity is higher than that of the peers.
Finally, the investor will evaluate the final factor. This is nothing but the summation of each comparison factor times its respective relative weight. Further, this final factor is multiplied by the previously calculated pre-money average to determine the valuation of a startup.
Pre-Money Valuation = Average Pre-Money Valuation*i=17RWi*CFi
Limitations of Scorecard Valuation
- One of the major limitations of the Scorecard Valuation is that one has to collect information regarding the pre-money valuations of similar companies. Besides this, there is increased subjectivity with regards to determining the relative weights and comparative factors.
4. First Chicago Method
The venture capital division of the First Chicago Bank in 1970 developed the First Chicago Method. This method was developed to value situation-specific businesses. In this method, both the market-oriented and analytical methods are combined to value a startup.
The very idea of using a combination of these methods is to develop different scenarios and to value each scenario independently. Then, the final valuation of a startup is undertaken by considering the probability of each of the scenarios.
So, the first step is to lay out different scenarios for the startup that one is trying to value. Typically, there exist three different scenarios. These include the Best-Case Scenario, the Mid-Case Scenario, and the Worst-Case Scenario.
Remember, that each of the scenarios will have its own financial projections and will be independent of the other scenarios. This means that each scenario will have different revenues, costs, earnings, cash flows, period of investment, and exit time.
a. Mid-Case Scenario
The most feasible and realistic scenario is the Mid-Case Scenario. This is because it is based on intensive due diligence processes that are undertaken by the investors.
b. Best-Case Scenario
The Best-Case Scenario is a positive scenario that demonstrates the expectations of the management team. As a result, such a scenario showcases the best financial outcomes that a startup can achieve.
Further, in this scenario, it is possible that the market in which the startup operates determines the maximum cap of the financial outcome. But this will depend on the industry in which a startup operates.
c. Worst-Case Scenario
The Worst-Case Scenario is the most pessimistic one of all the scenarios. This scenario reflects the fears of an investor that drive the valuation of a startup to the lowest point. In other words, the Worst-Case Scenario typically reflects a case in which the investor may lose all of his capital.
After laying out different scenarios, the next step under this method is to determine an estimated divestment price for each of the scenarios. To do so, the investors need to first determine the terminal value of a startup at the exit.
Just like the previous methods, the investors can determine the Terminal Value using multiples of the firms similar to the target business in terms of industry, geography, and stage.
After determining the Terminal Value, the next step is to determine the required rate of return. This rate of return will help the investors to undertake a valuation of each of the scenarios.
Many professional investors determine this rate of return internally. However, one can even use the CAPM model to calculate the required rate of return.
In case the investor uses the CAPM model, he needs to adjust such a rate for the illiquidity of the startup.
The following is the CAPM formula that investors may use to calculate the required rate of return.
r = Rf+ i* [E(Rm) – Rf] + lp
r = Required Rate Of Return
Rf= Risk-Free Rate (yield of high-quality bonds)
E(Rm) = Expected return of the market
[E(Rm) – Rf] = Expected market risk premium
i = Beta Coefficient for Asset i
lp= Liquidity Premium
To determine the valuation for each of the scenarios, the investors will take the summation of the cash flows projected for each of the scenarios discounted with the rate of return. Then, they need to add this summation to the Terminal Value that the startup will have at the time of exit.
Valuations = i=17CFtS(1+r)t+ TVS(1+r)h
Valuations= Valuation under Scenario s
h = investment horizon
CFtS= Cash Flow at period t and under scenario s
r = Required Rate of Return
TVS= Terminal Value under Scenario s
After the investors calculate the valuation for each scenario, the next step is to assign probabilities to each of them. These probabilities would depend upon how investors define each scenario and the number of scenarios they define.
Thus, the number of scenarios would vary between different startup valuations. It would majorly depend upon the skills and the experience of the investor.
The typical scenarios under the Chicago Method include:
After the investors have a proper valuation for each scenario, the final step is to undertake the weighted sum of all these valuations. This will result in the final valuation of the startup.
Startup Valuation = s=1NpS*Valuations
N = Number of Scenarios
pS= Probability of Scenario
Valuations= Valuation under Scenario s
Limitations of Chicago Method of Valuation
- Though this method offers a high level of freedom and flexibility to the investor. But it is a double-edged sword. That is the higher the number of scenarios, the higher is the complexity.
5. Risk Factor Summation Method
The objective of this method is to come up with a pre-money valuation for pre-revenue startups considering a broad set of factors.
Just like the Scorecard Method, the investors first have to find the average pre-money valuation of the comparable companies of the target startup. Then, they have to adjust such a value with the following twelve risk factors.
- Stage of Business
- Legislation or Political Risk
- Manufacturing Risk
- Sales or Marketing Risk
- Funding or Capital Raising Risk
- Competition Risk
- Technology Risk
- Litigation Risk
- International Risk
- Reputation Risk
- Potential Lucrative Risk
To adjust each of the above factors, the investors have to assign a grade to each and every factor as per the following cases.
- +2 = Very positive for the company growth and future exit
- +1 = Positive for the company growth and future exit
- 0 = Neutral for the company growth and future exit
- -1 = Negative for the company growth and future exit
- -2 = Very Negative for the company growth and future exit
Note that a positive grade (+1 or +2) reflects lower than the average risk for the target startup that the investors are valuing. A neutral grade represents that the respective risk factor is in line with that of the competitor companies. Likewise, a negative grade (-1 or -2) reflects that the target startup is more exposed to the respective risk factor than the competitor firms.
Then, the investors must positively adjust the average pre-money valuation of comparable companies with positive grades. Such an adjustment will increase the valuation by $250k for every +1 and by $500k for every +2. Likewise, the investors must negatively adjust the average pre-money valuation of comparable companies with negative grades. Such an adjustment will decrease the valuation by $250k for every -1 and by $500k for every -2.
Limitations of Risk Factor Summation Method of Valuation
- This method enables the investors to consider the important risk factors that they may have not considered otherwise. However, the increased subjectivity may increase the complexity.
5. Cost-to-Duplicate Method
This method of valuation values a startup by analyzing how much it would cost to set up an identical company from scratch. Such a cost is considered after taking into account the market value of the assets of the startup.
The major downside of this method is that it does not take into consideration the future potential tangible and intangible assets such as brand value or management strength.
Besides considering the cost of tangible assets, this method also considers the cost that has already been incurred. Such costs may include costs of developing prototypes, patent protection, or research and development.
It is extremely challenging for a startup investor to determine the value of the target company in which he intends to invest. This is because the level of uncertainty and the risks involved are too high. This may result in volatile valuations depending upon the method of valuation used.