How Are Startups Valued?
Startup valuation is never easy for any business. For startup companies with little to no capital or profits and an uncertain future, valuation is a daunting task.
For publicly listed and mature corporations with steady revenues and earnings, business valuation focuses on their earnings before interest, taxes, depreciation, amortization (EBITDA). It may also be based on other industry-specific measures. Either way, it’s daunting to value a new business venture that isn’t listed publicly and which may be years away from generating sales.
However, if you’re trying to raise capital for your startup venture or you’re thinking about investing in a startup, it’s essential to conduct startup market research and determine the startup value.
Often, startup businesses look for angel advisors to raise the much-needed capital to help the company get off the ground. Most startup businesses issue advisory shares in exchange for insight and contacts with startup advisors. The advisory shares are a form of startup advisor equity. It’s essential to know how to value your startup company.
In this article, we’ll discuss some popular methods you can use to value your startup company.
How To Value A Startup Venture
Startup businesses are notoriously difficult to value if they don’t have any operating capital or even a fully developed product, and you’ll be spending your money to get the business going.
However, some approaches, such as discounted cash flows, can value both established companies and startup ventures. Other approaches, such as cost-to-duplicate and stage valuation, are unique to startup ventures.
Let’s dive into startup valuation approaches.
Discounted Cash Flow Approach
You can value your startup business using the Discounted Cash Flow (DCF) approach. But to use this method, you may have to work closely with an investor or a market analyst.
To use this method, take your forecasted cash flows and then apply the expected rate of return on investment (ROI) or a discount rate. Typically, the higher the discount rate is, the riskier the startup venture is—and the better your growth rates must be.
The goal behind the DCF approach is that investing in young business ventures is risky when compared to investing in a mature company with consistent revenue and earnings.
Also, you should consider the First Chicago Method, which is an expansion of the DCF approach. This method considers three situations. In two scenarios, the startup venture performs poorly, based on projections, and, in the third, the startup performs better than expected.
Cost-To-Duplicate Method
The goal of this method lies in the name. Here, you’re determining how much it will cost to recreate your startup venture elsewhere—minus any intangible assets, such as your goodwill and brand.
To value your startup venture using this method, simply total the fair market value of your physical properties and assets. Also, you may include startup market research and development costs, patent expenses, and product prototype costs.
One primary drawback of this method is that it doesn’t inherently capture the full value of a business, especially if the startup company is generating revenue already. When determining your startup’s valuation, ignore irrelevant elements, such as customer engagement.
Stage Valuation Method
This is a developmental stage valuation approach that’s often used by venture capital firms and angel advisors to come up with an accurate range of startup estimates quickly.
The rules of stage valuation are often set by angel investors, depending on the startup’s stage of business development. The further the startup is along the development pathway, the lower the startup’s risk and the more it's worth.
Again, the particular value stages vary depending on the startup and the investors. Startup ventures that have nothing but a business plan will most probably get the lowest valuations from investors. As the startup company meets its development milestones, investors will assign a higher value.
Most private equity companies use an approach whereby they provide extra funding when the startup reaches a certain milestone. For example, the first round of business funding may provide money for the development of a specific product. Once the product is developed successfully, a subsequent round of financing is offered to mass-produce and market the product.
Market Multiple Method
This is one of the most popular methods of valuing startup businesses. This method works just like most multiples do. Here, you need to consider recent acquisitions in a similar market, and then you’ll need to determine a base multiple based on the value of those acquisitions. Next, value your startup using the base market multiple.
Risk Factor Summation Method
This approach values a startup business by considering all quantitative risks associated with the company that can influence the return on investment. For the risk factor summation approach, an estimated initial figure is computed for the startup business using any of the above valuations methods. The effect of this figure, whether positive or negative, on different business risks, is considered and then a determined figure is added or deducted from the initial value depending on the impact of risk.
After considering many risks and using the “risk factor summation method” to come to the initial estimated value of a startup business, the final value of the business is determined. Examples of business risks that you should consider include political risk, management risk, manufacturing risk, investment and capital accumulation risk, market competition risk, technological risk, and legal environment risk.
Final Thoughts
As a startup owner, you require a valuation estimate that you can justify to prospective investors. An accurate estimate can help you come up with your long-term fundraising strategy and keep your financing requests in perspective.
However, it’s essential to note that no startup valuation approach is completely accurate all the time. More often, you’ll need to work through multiple valuation methods and combine valuation approaches to find a fair and accurate market value for your startup.