Decoding Startup Valuation: Key Insights and Methods

What Is Startup Valuation?

Startup valuation refers to the determination of a startup's worth, considering the market dynamics within its industry and sector.

These factors include the balance (or imbalance) between demand and supply of money, the size of recent events, the willingness of investors to pay premiums to invest in the company and the level of need the company has for money.

What Is a Startup?

A startup company is a new business which is potentially fast growing and aims to fill a hole in the marketplace by developing and offering a new and unique product, process or service but is still overcoming problems.

Startup companies need to receive various types of funding in order to rapidly develop a business from their initial business model that they can grow and build up.

Difference Between Startup Valuation and Mature Business Valuation

Startup businesses will usually have little or no revenue or profits and are still in a stage of instability. It is likely their product, procedure or service has reached the market yet. Because of this it can be difficult to place a valuation on the company.

With mature publicly listed businesses that receive steady revenue and earnings it is a lot easier. All you have to do is value the company as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA).

EBITDA

EBITDA is best shown with the following formula - EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization

For example, if a company earns $1,000,000 in revenue and production costs of $400,000 with $200,000 in operating expenses, as well as a depreciation and amortization expense of $100,000 that leaves an operating profit of $300,000. The interest expense is $50,000 leading to earnings before taxes of $250,000. With a 20% tax-rate the net income becomes $200,000. With EBITDA you would add the £200,000 net profit to the tax and interest to get the operating income of $300,000 and add on the depreciation and amortization expense of $100,000 giving you a company valuation of $400,000.

With startup valuations there is no substantial information to base a valuation on other than assumptions and educated guesses.

What Will Get A Startup A Good Valuation?

A high startup valuation is based on the startup being able to show or possess the following things:

• Traction – One of the biggest factors of proving a valuation is to show that your company has customers. If you have 100,000 customers you have a good shot at raising $1 million
• Reputation – If a startup owner has a track record of coming up with good ideas or running successful businesses, or the product, procedure or service already has a good reputation a startup is more likely to get a higher valuation, even if there isn't traction.
• Prototype – Any prototype that a business may have that displays the product/service will help
• Revenues – More important to business to business startups rather than consumer startups but revenue streams like charging users will make a company easier to value
• Supply and Demand – If there are more business owners seeking money than investors willing to invest, this could affect your business valuation. This also includes a business owner's desperation to secure an investment, and an investors willingness to pay a premium
• Distribution Channel – Where a startup sells its product is important if you get a good distribution channel the value of a startup will be more likely to be higher.
• Hotness of Industry – If a particular industry is booming or popular (like mobile gaming) investors are more likely to pay a premium, meaning your startup will be worth more if it falls in the right industry.

What Will Reduce A Startup Valuation?

An investor will not pay a premium, or may not even invest if a startup contains or shows the following:

• Poor Industry – If a startup is in an industry that has recently shown poor performance, or may be dying off.
• Low Margins – Some startups will be in industries, or sell products that have low-margins, making an investment less desirable.
• Competition – Some industry sectors have a lot of competition, or other business that have cornered the market. A startup that might be competing in this situation is likely to put off investors.
• Management Not Up To Scratch – If the management team of a startup has no track record or reputation, or key positions are missing
• Product – If the product doesn't work, or has no traction and doesn't seem to be popular or a good idea
• Desperation – If the business owner is seeking investment because they are close to running out of cash

Funding Stages

Because startups typically go through a series of 'funding stages' their valuations can differ after each round of funding, and typically they'll want to show growth between each round, the usual funding stages are as follows,

1. Seed Funding – Typically known as the 'friends and family' round because it's usually people known to the business owner who provide the initial investment. But, Seed funding can also come from someone not known to the founder called an 'Angel Investor'. Seed Capital is often given in exchange for a percentage of the equity of the business, usually 20 percent or less, with funds raised usually between $250,000 and $2,000,000.
2. Round A Funding – This is the stage that venture capital firms usually get involved. It is when startups have a strong idea about their business and product and may have even launched it commercially. The Round A funding is typically used to establish a product in the market and take the business to the next level, or to make up the shortfall of the startup not yet being profitable. Funds raised usually fall between $2 and $15 million.
3. Round B Funding – The startup has established itself but needs to expand, either with staff growth, new markets or acquisitions
4. Debt Funding – When a startup is fully established it can raise money through a loan or debt that it will pay back, such as venture debt, or lines of credit from a bank.
5. Mezzanine Financing and Bridge Loans – Typically the last round of funding where extra funds are acquired in bridge financing loans in the run-up to an IPO, acquisition, management buyout, or leveraged buyout. This is usually short-term debt with the proceeds of the IPO or buyout paying it back.
6. Leveraged Buyout (LBO) – A Leveraged Buyout is the purchase of a company with a significant amount of borrowed money in the form of bonds or loans instead of cash. Usually the assets of the business being purchased are used as leverage and collateral for the loan used to purchase it.
7. Initial Public Offering (IPO) – An Initial Public Offering is when the shares of a company are sold on a public stock exchange where anyone can invest in the business. IPO opening stock prices are usually set with the help of investment bankers who help sell the shares.

Why Is Startup Valuation Important?

Valuation matters to business owners because it decides the share of a company that they have to give away to an investor in exchange of money. The higher the valuation of a company the less that company needs to give to an investor in terms of shares and equity in exchange or the more money in an investment they are likely to receive.

With a startup the value of a company at the start or 'seed' stage will be close to zero. However, the valuation will be higher than that because you have to factor in growth potential in order to get investors to part with their cash.

For example, a startup trying to secure 'seed' investment will offer 10 percent of the company for $100,000. This values the company at $1,000,000 but that doesn't necessarily mean it is actually worth $1,000,000 but the startup is suggesting to the investor that there is a potential for the company to be worth that figure after growth and investment.

Valuation is also important to investors, it is the main factor that suggests how much of a return they will get on their investment.

Do Startups Need A High Valuation To Be Successful?

The success of a startup doesn't rely on it receiving a high valuation, and in some cases it is better to not receive a high valuation. When you get a high valuation for your seed round, you need a higher one for the next funding round, meaning that a lot of growth is needed between rounds.

A good general rule to follow is that within 18 months a startup will need to show that it grew ten times. This is usually achieved with one of the two following strategies.

1. Go big or go home – A startup can raise as much money as possible at the highest valuation possible, spending that money to encourage as much growth as possible as quickly as possible. If successful a startup will have a much bigger valuation in the next funding round and often, the 'Seed' round will pay for itself.
2. Pay as you go – A startup would only raise money that it needs, spending as little as possible whilst aiming for steady growth. 

What Methods Are Good Ways to Value Startups?

There are many different methods used in deciding on a startup's valuation, whilst all of them differ in some way, they are all good to use.

• Venture Capital Method
• Berkus Method
• Scorecard Valuation Method
• Risk Factor Summation Method
• Cost-to-Duplicate Method
• Discounted Cash Flow Method
• Valuation By Stage Method

Venture Capital Method

The Venture Capital Method (VC Method) is one of the methods for showing the pre-money valuation of pre-revenue startups. The concept was first described by Professor Bill Sahlman at Harvard Business School in 1987. It uses the following formulas:

• Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
• Then: Post-money Valuation = Terminal Value ÷ Anticipated ROI

Terminal (or Harvest) value is the startup's anticipated selling price in the future, estimated by using reasonable expectation for revenues in the year of sale and estimating earnings.

If we have a tech business with a terminal value of 4,000,000 with an anticipated return of investment of 20 times and they need $100,000 to get a positive cash flow we can do the following calculations.

• Post-money Valuation = Terminal Value ÷ Anticipated ROI = $4 million ÷ 20X
• Post-money Valuation = $200,000
• Pre-money Valuation = Post-money Valuation – Investment = $200,000 - $100,000
• Pre-money Valuation = $100,000

Berkus Method

The Berkus Method assigns a range of values to the progress startup business owners have made in their attempts to get the startup off of the ground. The following table is the up-to-date Berkus Method,

Scorecard Valuation Method

The Scorecard Valuation Method uses the average pre-money valuation of other seed/startup businesses in the area, and then judges the startup that needs valuing against them using a scorecard in order to get an accurate valuation

• The first step is to find out the average pre-money valuation of pre-revenue companies in the region and business sector of the target startup
• The next step is to find out the pre-money valuation of pre-revenue companies using the Scorecard Method to compare. The scorecard is as follows,
  • Strength of the Management Team – 0-30 percent
  • Size of the Opportunity – 0-25 percent
  • Product/Technology – 0-15 percent
  • Competitive Environment – 0-10 percent
  • Marketing/Sales Channels/Partnerships – 0-10 percent
  • Need For Additional Investment – 0-5 percent
  • Other – 0-5 percent
• The final step is to assign a factor to each of the above qualities based on the target startup and then to multiply the sum of factors by the average pre-money valuation of pre-revenue companies

Risk Factor Summation Method

The Risk Factor Summation Method compares 12 elements of the target startup to what could be expected in a fundable and possibly profitable seed/startup using the same average pre-money valuation of pre-revenue startups in the area as the Scorecard method. The 12 elements are:

• Management
• Stage of the business
• Legislation/Political risk
• Manufacturing risk
• Sales and marketing risk
• Funding/capital raising risk
• Competition risk
• Technology risk
• Litigation risk
• International risk
• Reputation risk
• Potential lucrative exit

Each element is assessed as follows:

• +2 - very positive for growing the company and executing a wonderful exit
• +1 - positive
• 0 - neutral
• -1 - negative for growing the company and executing a wonderful exit
• -2 - very negative

The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2).

Cost-to-Duplicate Method

This approach involves looking at the hard assets of a startup and working out how much it would cost to replicate the same startup business somewhere else. The idea is that an investor wouldn't invest more than it would cost to duplicate the business.

The big problem with this method is that it doesn't include the future potential of the startup or intangible assets like brand value, reputation or hotness of the market.

With this is in mind, the cash-to-duplicate method is often used as a 'lowball' estimate of company value.

Discounted Cash Flow (DCF) Method

This method involves predicting how much cash flow the company will produce, and then calculating how much that cash flow is worth against an expected rate of investment return. A higher discount rate is then applied to startups to show the high risk that the company will fail as it's just starting out.

This method relies on a market analyst's ability to make good assumptions about long-term growth which for many startups becomes a guessing game after a couple of years.

Valuation by Stage

The valuation by stage method is often used by angel investors and venture capital firms to come up with a quick range of startup valuation.

This method uses the various stages of funding to decide how much risk is still present with investing in a startup. The further along a business is along the stages of funding the less the present risk.

• A valuation-by-stage model might look something like this:
• Estimated Company Value Stage of Development $250,000 - $500,000
• Has an exciting business idea or business plan $500,000 - $1 million
• Has a strong management team in place to execute on the plan $1 million – $2 million
• Has a final product or technology prototype $2 million – $5 million
• Has strategic alliances or partners, or signs of a customer base $5 million and up

Startups with just a business plan will receive a small valuation, but that will increase as they meet developmental milestones.

Reasons to Do Startup Valuation Correctly

There are many valuation tools and methods out there so knowing which ones to use and for reasons is just as important as knowing how to use them.

1. You are what the market says you are – If investors think a startup is worth $500,000 then that is what it is worth. The business owner might think it is worth more but if they are unable to raise money with a valuation above $500,000 then that is market valuation.
2. You can tell the market what you're worth – It is possible to show the market how much a startup is worth using one of the above valuation methods.
3. You're not worth anything until you make a profit – If a startup isn't making a profit it probably isn't worth very much. But it's important for a startup to focus on the future and estimate how many years it will take to become profitable.

Common mistakes

Do Your Research

It is important to research and get an actual factual basis when valuing a startup. Many business owners seem to pluck valuation figures out of nowhere, which puts off potential investors.

It is useful to compare the startup to similar companies in the same industry and geography to help determine worth. Sites like BizBuySell and BizQuest can help with this.

It can also be useful to consult accountants and lawyers to help in valuing your startup.

Don't Get Carried Away

For many startup owners it's easy to get carried away and value their startup at the highest valuation possible. Whilst this is likely to help them secure investment they forget that they'll likely have to deliver on the expectations they've set with their valuation.

Business owners should be careful about overvaluing their startup, and perhaps show a little restraint.

Frequently Asked Questions

• Should I only use one method?

You can use one or multiple methods and get multiple different valuations. Remember all of these methods involve guesswork.

Also, as these things are subjective, an investor might feel the startup has a much higher or lower valuation than the one you worked out yourself.

• What do angel investors target for returns?

Some angel investors target 5X to 10X return on investment (ROI) in four to eight yields. This gives them a return rate of about 25 to 75 percent. Others target 30X ROI. These are just rules of thumb, what return an angel investor will want on their investment depends entirely on the individual investor.

• Why does startup valuation matter?

Valuation matters to business owners because it decides how much investment they can receive and how much of the startup they might have to give away to receive that investment.

• How to calculate your valuation at the early stages?
  • Work out how much money you need to grow to a point that will enable your startup to reach the next round of investment.
  • If this is $100,000 the investor is unlikely to negotiate downward because you've shown that this is the minimum you need to grow your business, which is in the investor's interests.
  • Then you need to figure out how much of the company to give to the investor, usually this will be less than 50 percent to keep the founder with a controlling share of the business. Typically at the start of the business this is as small as possible.
  • Let's say it's 5 percent - 20 percent equity that you give away to get the $100,000.
  • This puts the pre-money valuation of your startup to $500,000 if you give away 20 percent of the company, and $2,000,000 if you give away 5 percent of the compa.ny
• Do you need a high valuation?

While a high valuation can lead to a larger investment it isn't necessary for your startup. If you start the seed stage with a high valuation it can be difficult to grow the company in the next rounds of funding.

• How much money should I raise?

It is best to discuss this with the potential investor so that the business owner and the investor agree, especially as this figure will go on to decide the startup's valuation.

Need More Help With Startup Valuation?

If you need help with the legal aspects of startups or venture capital you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.