The best guide on how to value a startup
25 November 2019
Valuation is not something to take lightly and is no simple task. Many people think that placing value on something is a combination of science and intuition. The science of the process is learned by researching valuation for certain companies and can be done using a number of steps. Using intuition is more focused on how powerful the team is, what are the leads they are having, and how innovative is their solution.
Knowing how to value a startup is a common question, and there is no single answer. When talking about a startup that does not have high revenues, assigning a valuation can be difficult. If we look at mature businesses that are already listed and have steady revenue, there are some methods that we can use to determine value.
Still, if we want to know how to value a startup, we need to dig deeper. A startup is always going to be harder to value. This is because it has not gotten any relevant sales. To get capital for a startup, it is important to find out what the startup value is.
Keep reading more about this topic in this article created by our team at TMS, and have a look at these valuation methods that are recommended by investors and founders. They are going to help in figuring out how to value a startup.
Knowing how to value a startup
Image source: Act165
When wanting to raise capital for a startup, or wanting to invest in one, you first need to find out the company’s worth. As an early-stage investor, deciding if an investment should be made in a startup means that the exit size should be calculated. These startup valuation methods depend on what industry are we talking about and its results so far.
If a business owner has demonstrated that his startup is worth a high amount, the investors are more likely to invest in that company. Understanding how to value a startup can also be art, not just science, especially when we think about startups that do not have data to use.
To put it simply, a startup is worth what amount someone is ready to pay. It is possible to have a startup valuation calculator method that can help a business owner to asses and assign a value for his startup. This usually needs to make sense for both parties to have something get done.
How to Value a Startup – Methods to use
Venture Capital Method
The Venture Capital Method is one of the most well-known ways to determine value. It shows a pre-money valuation of pre-revenue startups. This startup company valuation was created by Professor Bill Sahlman at Harvard Business School back in 1987.
The formula used is:
- Return of Investment = Terminal (or Harvest) Value ÷ Post-money Valuation
- Post-money Valuation = Terminal Value ÷ Anticipated ROI
As you can surmise from the name, Cost-to-Duplicate Method approach involves calculating how much it can cost to build a company like it from scratch. A smart investor would not pay more than it would cost to duplicate.
The Cost-to-Duplicate Method approach focuses on physical assets to determine a fair value. For example, if we want to find out the cost-to-duplicate of an IT business, we need to look at the labor costs, and how much programming has been used to create the product.
Human Capital Plus Market Value Method
Learning how to value a startup is no easy task for any investor. This is because each of them has a low intangible asset ratio. So the investor needs to calculate the potential of the ideal together with the team.
There are a few ways to evaluate. One of the first aspects to evaluate is the team and what their overall experience is. People who have developed the startup are going to predict the value of it. The next is more math-related. When some rough estimations are available, an investor can start thinking about the potential of a startup.
Using the Berkus Method is quite simple. All you need to do is set a range of values for the progress of the startup. Check this table if you want to understand how to value a startup using the Berkus Method.
|If Exists:||Add to Company Value up to:|
|Sound Idea (basic value)||$1/2 million|
|Prototype (reducing technology risk)||$1/2 million|
|Quality Management Team (reducing execution risk)||$1/2 million|
|Strategic relationships (reducing market risk)||$1/2 million|
|Product Rollout or Sales (reducing production risk)||$1/2 million|
Risk Factor Summation Method
One of our favorite startup valuation method is the Risk Factor Summation Method. The Risk Factor Summation Method is similar to the Berkus one, but it is a bit more advanced. It also involves a level of managing risk and asks the user to assess other ones as well. They are:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising the risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
All the risks above are numbered as follows:
- +2 very good for growing the company and doing an exit
- +1 good
- -1 negative for growing the company and doing an exit
- -2 very negative
Many early investors choose this approach because it offers a good indication of what the market would pay for a company. How these method works are that it values the company compared with recent acquisitions of similar companies from the market.
This practice uses data based on revenue, cash flow, earnings, and net income. The previously listed are the most common ones that get used. What is powerful in this method is that it shows the market conditions using real indicators.
Discounted Cash Flow (DCF)
When a startup is performing well, that means it is bringing cash annually. We can easily say that the current value of the startup is the same as the future cash flows that will happen over the upcoming years. This is exactly the idea behind this method.
If you are thinking about cash flows in certain years, you’ll want to know what is going to happen after. This is one of the questions that gets answered by the Terminal Value. Let’s say the business is going to grow at a normal pace and keep generating cash flows for a certain number of years. You can use the Terminal Value formula: TV = CFn+1(r-g) where:
- r = discount rate
- g = expected growth rate
Valuation by Stage
Another way of discovering how to value a startup is by using the Valuation by Stage. Valuations for each round of financing have a big impact on the investors and entrepreneurs behind a startup. Thanks to improved startup resources, it is now easier than ever to understand how to place value.
Startups usually have a series of “funding stages” where their valuation is going to be different after each one. The main idea is that they should grow after each round, together with the usual funding stages.
Comparison of Valuation Method
Valuations need information from other companies that are similar to a startup that is being checked. This means that investors check out competitors or other companies from the same industry to understand how the one they are analyzing is behaving.
Analyzing comparable venture investments is one of the most common ways that founders and investors can look at startup valuation. It is also probably one of the best ways to understand how to value a startup.
Startup Valuations tools
Some tools can help on this topic, so let’s have a look at them and how they can do that.
High Tech Startup Valuation Estimator by Cayenne Consulting
If you need a startup valuation calculator, this is an interesting alternative. The high level of risk associated with valuation is known in the investor’s world. So check this option, it might be of help.
Startup Valuation Calculator by EquityNet
The Startup Valuation Calculator is another tool that can be of great help to help determine the value of a startup. What it does is it helps you estimate better a business valuation. It does this using real market data gathered by EquityNet from more than 3,000 companies in America.
Pre-Money and Post-money valuation calculator
What this calculator does is use simple math to help you free your mind and be able to do more important things. Negotiating a startup valuation consumes a lot of energy. By using this tool, you will be able to do multi-directional math, and you will get two values from investment amount, investor’s equity, pre-money, or post-money evaluation.
The industry matters
Each industry has its way of doing the valuation of a startup. If we take a look at technology startups, we can see that they have a bigger valuation compared with Saas CRM. It is important to research recent investments before you want to approach any investors.
What this means is that if a startup is operating in a space where the market is depressed, the amount that an investor is going to give is reduced, regardless of the success the company has. Investors only pay a premium over the average for a startup if:
- The sectors it is in has shown low performance.
- The sectors it is in is highly commoditized.
- The sectors it has has a large set of competitors, with little difference between the sets.
Ending thoughts on how to value a startup
In conclusion, understanding how to value a startup is an art that develops in time. Learning how to do it is also about practice and what information you can get your hands on.
If you enjoyed reading this article on how to value a startup, you should check out this one about Steve Jobs leadership style.
We also wrote about a few related subjects like IPO process, IPO lockup period, risk assessment matrix, business process modelling, business model innovation, business model vs business plan, accelerator vs incubator and startup funding stages.