The first part of our blogpost defined the purpose of startup valuation, this part provides an insight into the most popular startup valuation methods.
Venture Capital Method
When determining the valuation by applying the Venture Capital method, investors consider their expected future return on investment. First, the investor estimates the startup’s future selling price (terminal value), considering the expected future revenues of the company as well as the transactions of similar companies.
Then the post-money company value is calculated by reducing the terminal value by the investor’s expected return. The pre-money (pre-investment) company value is computed by subtracting the invested capital from the post-money value.
Valuation by Stage Method
Valuation by Stage is a popular method among investors due to its simplicity and rapidity. This method assigns a range of valuations based on the maturity of the startup. This range is determined based on market data and then applied for new transactions.
The startup value might increase as follows, after meeting developmental milestones:
- existing idea and business plan: USD 250,000 – 500,000;
- particularly exciting business idea and business plan: USD 500,000 – 1 million;
- quality team with all the necessary competences: USD 1 – 2 million;
- prototype / final product: USD 2 – 5 million;
- strategic alliances and customer base: above USD 5 million.
These ranges may vary from sector to sector. Numerous valuation tools can be accessed online, and one can find detailed lists of benchmarks and multipliers, too. One of the most popular data sources is that of Aswath Damodaran, professor of New York Stern Business School.
This simple method was created by Dave Berkus American venture capital expert in the ‘90s and revised a few years ago. The Berkus method lists the factors needed to get the startup off the ground and assigns a value of USD 0.5 million to each factor. The method describes five key factors, thus determining startup value in a range of USD 0-2.5 million.
The following success factors are considered in the course of the valuation:
- sound and viable business idea,
- existing prototype,
- strong and competent team,
- strategic partnerships,
- product rollout or sales.
Scorecard Valuation Method
The Scorecard Valuation Method uses the average pre-money valuation of comparable startup companies. As the first step, we need to identify companies of similar stage, which operate in the same sector and region, and get their average pre-money valuation.
As a next step, we thoroughly analyse whether our startup is stronger or weaker than the comparable companies, based on the aspects listed below. The result of the comparison is to be used to assign weights to each factor, bearing in mind the maximum weight of the given factors (e.g. in case our team is less competent than that of the comparable companies, we may assign a 15-20% weight instead of 30%).
|strength of the management team||30%|
|size of the opportunity||25%|
|need for additional investment||5%|
The final step is to sum up the weights assigned to the above factors and then to multiply the sum of factors by the average valuation of the comparable companies.
Risk Factor Summation Method
Similarly to the Scorecard Valuation Method, the Risk Factor Summation Method is based on the average valuation of a reference group. This method defines 12 risk factors, assesses how much our startup is prone to these risks and assigns a value of (-2) – (+2) to each risk factor accordingly (+2 represents the most positive outcome for our startup). The startup is to be assessed by the following risk factors:
- strength of the management team, lack of competences
- stage of the business (there is more uncertainty and more risks attributed to early-phase companies)
- legislation / political risk
- manufacturing risk
- sales and marketing risk
- funding risk
- competition risk
- technological risk
- litigation risk
- international risk
- reputation risk
- potential lucrative exit
The average valuation is then adjusted positively by USD 250,000 for every +1 and negatively for every -1.
The Cost-to-Duplicate Method assesses the cost to replicate the startup company. This approach determines the value of the company as a sum of investments in tangible assets and labour. An advantage of this method is that investors can check or estimate these investments easily and because these investments were performed in the past, there is no uncertainty.
In case of a software business, this approach would look at the labour costs of programmers and the time devoted to software development. The problem with this method is that it does not include the future potential of the startup or intangible assets, such as brand value or reputation. With this in mind, this method is often used as a lowball estimate of company value.
Book Value Method
The Book Value Method is based solely on the tangible assets of the company, with the value at which they are recorded in the company’s financial reports. This method does not take into account the future profitability of the company, and is usually applied when the company is going out of business.
This method selects a significant and measurable property of the startup, then compares it with a reference company. The ratio of the two startups’ properties are used to calculate the company value.
For example, if the reference company was valued USD 7.5 million and it has 250,000 active users, we may say that each user of the company added USD 30 to the company value. If our company has 125,000 users, then – based on the previously calculated value per user – our startup’s value is USD 3.75 million. This method might seem too simple but in fact, it may provide a reasonable estimate for company value.
Discounted Cash Flow Method
The Discounted cash Flow Method estimates how much cash flow (revenues and expenses) the company will produce. The calculation is usually based on a 5-year financial plan, and forecasts a terminal value for the period after five years. Then it reduces the cash flows by a discount factor, which reflects the systematic risks or the expected return on alternative investments.
The reason for discounting the cash flows is that the time value of money is not constant. It means that we value USD 10,000 now and at a future point in time differently. The money, which we currently possess might be placed as a deposit in a bank or be invested in real estate or other businesses. Whereas if we are going to receive the same amount of money in the future, we miss on the accumulated interest/profit. Moreover, it is uncertain and risky, whether we will receive these future amounts, which calls for further adjustment in the course of our calculation.
Estimating a company’s future cash flows is not an easy task and the accuracy of the forecasts greatly contributes to the result. Therefore, one needs to have good analytical skills to apply this method.
First Chicago Method
The First Chicago Method complements the previous valuation methods. It considers three different scenarios and checks how much the company value changes, given a best case, a normal case and a worst case scenario. This method helps investors, as it shows how conservative or ambitious the founder’s business plan is.
Startup owners often assume that the calculations they prefer result in the permanent and right company value. In fact, the actual valuation is rather determined by the market. The valuation is validated later, during a following funding round, and finally when the company is acquired (exit) or goes public (IPO). It is not worth insisting on a valuation, business owners shall rather explore exit opportunities and work on increasing shareholder value.