Startup

Different Startup Valuation Methods to Assess Your Startup’s Worth

Valuation of a startup or an entrepreneurship is to ascertain the company’s growth potential and future success of a business. In simple words, startups are new business enterprises started by entrepreneurs to develop unique ideas or technologies for the public and other businesses.At the initial stage, the valuation of a startup is very complex as they are based only on the concept or idea and future execution of a business plan. Investors have devised no. of startup valuation methods to see the business’s real potential value.

What is Startup Valuation?

Startup valuation is the process of evaluating the value of a startup company. The valuation process isessential as it helps determine the value of the startup businesses at the pre-revenue stage. The process holds importance for business owners and investors as they are keen to know what percentage of shares or equity to give an investor in exchange for funds invested.

Importance of Startup Valuation

With the rising trend of startups and entrepreneurship, there is a growing need to attain a strong valuation, making startups a potential place for investment or funding the growing business at anearly stage. A right or wrong startup valuation can be a deal maker or breaker.A hired externalvaluatorcan help identify key performance indicators like revenue capital or profit estimation and alsopresent the future growth potential. If a startup has a higher valuation, then the startup can offer a lesser amount of equity or shares in exchange for funds to an investor.

Different Startup Valuation Methods

The different types of Startup Valuation Methods usedby angel investors and venture capitalists to know the future growth of the company. Some of the Startup Valuation Methods discussed below are:

The Berkus Method

This method is a valuable tool for determining the valueof early-stage startups or pre-revenue startups, particularly businesses that don’tstart their sales or services. This system of startup valuation was created by venture capitalist Dave Berkus.The Berkus Method allows startups to access available opportunities after considering the assets’ quality.

The following key factors are considered for evaluation are:

• A Working Prototype (technology)
• Sound Idea (basic value)
• Quality Management Team (execution)
• Strategic Relationships (go-to-market)
• Product Rollout or Sales (production)

Scorecard Valuation Method

The Scorecard method helps angel investors to estimate the startup value by calculating a composite score based on the performance of a business organisation in a similar market space. A SWOT ^[1](Strengths, Weaknesses/Limitations, Opportunities, and Threats) analysis is conducted by adding the projected growth of the company, current value and the capital involved.In simple words, the scoreboard method works by comparing startups to others they have already funded.

Under this valuation method, some key factors are mentioned below:

• Strength and Quality of the Management Team;
• Market Size;
• Product/Technology;
• Competitive Environment;
• Growth and Engagement;
• Additional Investment.

Risk Factor Summation Method

A Risk Factor Summation method is a combination of the Scorecard Method and Berkus Method. It evaluates all major risk factors that may affect the investors’ return on investment. A Startup’s base value is compared with all the associated risks under this method. The baseline value is adjusted for 12 common risk factors for Startup valuation are:  

1. Management of the Risk,
2. Stage of the business,
3. Legislation/political risk,
4. Manufacturing risk,
5. Sales and Marketing risk,
6. Funding/capital raising risk,
7. Competition risk,
8. Technology risk,
9. Litigation risk,
10. International risk,
11. Reputation risk,
12. Potential lucrative exit.

The final value of the startup is determined after taking all kinds of major risks and implementing the Risk Factor Summation (RFS) to the estimated cost of the startup. An appropriate grading is given based on the Risk Factor Summation (Each risk factor is assigned a grade from ++, +, 0, -, or –)

Venture Capital Valuation Method

Developed by Bill Sahlman in 1987, most Venture Capital Firms adopt this method for valuation to establish an understanding of the value of an early-stage startup using the basic framework. The Venture Capital valuation method emphasises an investor’s exit value (expected future returns) on the funds invested at thepre-revenue stage once the final objectives are achieved. Under Venture Capital Method, a term sheet defines the specific conditions of the venture capital investmentsbetween the investing firm and the entrepreneur.

Discounted Cash Flow Method

Startups or early-stage businesses can also be valued using the Discounted Cash Flow Method. The discounted cash flow (DCF) model is the most versatile method for business valuation. Since investing in a startup is considered riskier as compared to already established businesses, consistently operating and earning revenues.

Discounted Cash Flow method emphasises projecting the cash flow movements of a startup. A forecasted future cash flow of a startup is taken into account for evaluating the expected rate of return on investment (discount rate). It is generally said that higher the discount rate, riskier the investment is, if the value obtained under this startup valuation method is greater than the cost of investment, then an investment opportunity is considered positive.

Conclusion

A business owner will expect a high valuation for his company; in contrast, pre-revenue investors would prefer a lower value that promises a significant return on investment.Startup Valuation methods never present the exact value of a startup. Market advisors and financial analysts are often involved in the valuation process. An investor must use multiple startup valuation methods to calculate accurate startup valuation.

Read our Article: Brief on business valuation methods in India