Every startup founder will, at some point, need to consider their startup’s valuation. But to do so, you’ll first need to understand the many startup valuation methods out there and when each of them is used.
Most startups require funding to grow their operations, products and services, teams, and their footprint. But it’s not always possible for businesses to self-sustain this growth.
That’s why most startups look to venture capital (VC) firms, funds, and angel investors, as well as incubators in a bid to get funding to sustain their growth plans.
But to get this funding, a startup would need to determine the amount of money required to approach these investors and disclose how much their company is worth. And that’s where startup valuation comes in.
Each startup valuation method offers certain insights into the company, while some are bound to the stage the startup is in.
For example, you’ll see that some startup valuation methods are mainly used by pre-revenue startups while others are for operational startups.
In this article, we’re going to explore the 9 main startup valuation methods used by investors.
What is a startup valuation?
A startup valuation is an attempt to determine the value of a startup.
But that’s not all.
Startup valuations offer insights about whether a startup will be able to use new capital wisely, meet expectations by both its investors and customers, and continue to grow.
The startup valuation process takes into account several factors:
- The industry and sector
- Market forces of supply and demand for its product or services,
- How much the company needs in terms of money along with investors’ willingness to invest in the company
- The team’s track record
- The business model
- The competition and their performance
- Goodwill
Why valuations are important
To show investors what their business or startup is worth, founders need to find a way to offer an estimate. That ‘way’ is the startup valuation.
But not all startups are the same.
Some are pre-revenue, which makes it harder to determine their worth, because they don’t have any actual figures to use.
Then there are startups that have been around for some time and are generating revenues. These are easier to valuate than startups without revenue because they use concrete and available data to forecast future performance.
When looking at pre-revenue startups, investors want to see an estimate and forecast of how these companies will perform over the medium and long-term. They need validation that these pre-revenue startups have enough potential to grow and become revenue-generating startups.
It’s worth mentioning that startup valuation methods may vary depending on the stage each startup is in.
Startup valuation methods
Now let’s look at those startup valuation methods.
1. Cost-to-duplicate
This startup valuation method estimates a startup’s value by calculating how much it would cost to build a similar startup from scratch. It looks at physical assets to see their fair market value.
The idea behind the cost-to-duplicate method is that an investor wouldn’t pay more than the cost to create a duplicate of the startup that’s looking for funding.
Downside of this method:
The problem with the cost-to-duplicate approach is that it doesn’t take into account the startup’s growth potential including revenues, profits, and overall ROI. It also doesn’t give value to intangible assets like partnerships and brand value.
And because of this focus on physical assets only, the cost-to-duplicate approach is often seen as ‘unfair’ and a means to “lowball” a company’s estimated value.
2. Market multiple
One of the most popular and widely-used startup valuation methods is the market multiple approach.
It’s a venture capital investor favorite because it provides a good estimate of what the market would be willing to pay for a startup.
The market multiple valuation method estimates the value of a startup based on acquisitions of similar businesses in the market. Based on the information gathered from these recent acquisitions, a startup’s financial advisor would use a base multiple to value the startup.
This method is primarily used for startups that are already generating revenues. To get an estimate of the startup’s value, the multiple is multiplied by either the company’s revenues or its earnings.
It’s important to factor in the target startup’s stage of development compared to its peers. For example, if the startup looking to get valued is at an earlier stage compared to recent market acquisition, then other financial estimates need to be taken into account.
Downside of this method:
It’s not as easy or as simple to find companies in the same niche or size or with the same volume of market transactions to compare a startup to.
Unlike publicly-traded companies, startups, especially early-stage startups, rarely share inside information like deal terms.
All of this makes the Market Multiples valuation method harder to carry out.
3. Discounted cash flow (DCF)
The discounted cash flow (DCF) valuation method works best with startups that have begun generating revenue or profit.
The DCF method uses projections of a startup’s future free cash flow, then discounts it based on the Weighted Average Cost of Capital (WACC), which is the required rate of return or the hurdle rate, which investors expect to earn relative to the risk of the investment.
However, a high discount rate is often applied to startups due to the high risk of their ability to generate the estimated cash flow.
The DCF valuation method is very detailed and captures all future expansion plans. However the challenge with this method is that it depends on the analyst’s or financial advisor’s ability to predict how the company will perform in market conditions over the forecast period and provide assumptions about a startup’s long-term growth.
4. First Chicago Method
A two-step valuation method, the First Chicago startup valuation approach uses both the DCF approach and the comparable multiples method.
It calculates financial forecasts using three different scenarios; best case, base case, and worst case, then the comparable multiples method is used to reach the estimated terminal value for all scenarios.
A probability is then assumed for each scenario and the value is the weighted average of all events.
The First Chicago method gives investors both the positives associated with the company and the risks of investing in it.
5. Venture Capital Method
The Venture Capital Method, known as the VC Method or VC valuation method, is used mainly by pre-revenue startups because it provides a pre-money estimate.
The VC valuation method predicts a startup’s ROI and its terminal (or harvest) value, which is an estimate for how much the startup would sell for in the future.
To explain this better, let’s first understand what the terminal or harvest value is and then look at the formulas the VC valuation method uses.
The “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.”
(UpCounsel)
The VC valuation method uses two main formulas:
- Return on investment (ROI), which is calculated by dividing the terminal value or harvest value by the post-money valuation
- Post-money valuation, which involves dividing the terminal value by the anticipated ROI
Let’s take an example. If a business has a terminal value of $7 million and an anticipated ROI of 14X. To get a positive cash flow, the business needs $100,000.
Using the VC method, the calculation will look like this:
- Post-money Valuation = Terminal Value ÷ Anticipated ROI = $7 million ÷ 14X = $500,000
- Pre-money Valuation = Post-money Valuation – Investment = $500,000 – $100,000 = $400,000
6. The Berkus Method
This startup valuation method relies on several elements. The main ones are:
- How sound is the startup idea?
- Is a prototype available?
- Is there a quality risk management team?
- Are there strategic relationships?
- The potential of having an established product or sales.
The Berkus Method doesn’t involve analyzing estimated financials “except to the extent that the investor believes in the potential of a company to reach over $20 million in revenues by the fifth year of business,” according to Dave Berkus.
When it comes to valuing startups without revenue, the Berkus Method caps valuations at $2 million. Post-revenue startups, on the other hand, are capped at $2.5 million.
It’s worth mentioning though that this method doesn’t take various market factors into consideration. That said, the Berkus Method’s “limited scope” is considered “useful for businesses looking for an uncomplicated [valuation] tool.” (Brex)
The Berkus Method table
The Berkus valuation method is often used in the valuation of pre-revenue startups.
7. Scorecard Valuation Method
The Scorecard Valuation Method uses a kind of scorecard or scoring system to offer an accurate valuation. In a way, it compares the target startup to its peers.
To determine a startup’s value, the Scorecard Valuation Method looks at the average pre-money valuation of neighboring startups in the same geographical location and business sector as the startup that’s looking to be valued.
Used by angel investors, this startup valuation method measures a startup’s success based on a number of reference points. Using the scoring system, each point of comparison is given a score or percentage so the overall valuation can be calculated in the end.
Here’s an overview of what the scoring process looks like:
A factor is then assigned to each of the above-mentioned qualities for the target startup. Financial advisors then multiply the sum of these factors by the average pre-money valuation of similar pre-revenue companies to arrive at the valuation.
If your startup appears to have higher-than-average benefits and qualities based on those calculations then it will get a higher valuation and become a promising investment.
8. Risk Factor Summation Method
The risk factor summation method estimates the value of a startup by considering all business risks that may affect the investors’ ROI.
The risk factor summation valuation approach involves two stages or steps to reach the final startup valuation.
First, a startup or financial advisor would have to use any of the startup valuation methods included in this article. Then, they’d include all potential risks associated with the business.
Financial advisors view the risk summation method as a combination of the Scorecard and Berkus methods along with a detailed estimate of investment risks.
Meanwhile, the scoring process begins at -2 which indicates “very negative” or highly risky all the way to +2, which means there’s a positive opportunity with potential for a successful and lucrative exit.
9. The Book Value Method
Similar, in a way, to the cost-to-duplicate method, the book value approach gives startups an asset-based valuation. However, it’s considered to be much simpler.
A startup company’s book value is basically its total assets minus its liabilities, reflecting the net worth of the startup.
Tips to selecting a startup valuation method
Now that we’ve tackled the most common startup valuation methods, let’s look at what startup founders need to consider before selecting one or more of those methods.
Here are 3 tips to help you choose:
1) Look at businesses in your industry and geographical area and what valuations they’ve received and how much money they’ve raised. This will give you an indication of what to expect.
2) Do not stick to one approach. Both investors and startup owners use several startup valuation methods because it helps them reach a better average valuation.
3) Hire a financial advisor like Stride to help you decide on the best valuation methods for your business, support you with various valuation services, and conduct them for you.
Stride’s tips and notes about startup valuations
You’ll often hear startup founders asking questions like “Which valuation method gives the highest valuation?”
The truth is, there’s no method that gives a higher valuation over another. In fact, most startups and investors use several valuation methods to get an average valuation.
Another widely-asked question is: “What is a good valuation for a startup?”
And it would be unfair to say that there’s no such thing as a ‘good valuation’ and a ‘bad valuation.’
Every startup is a unique case.
While there are competitors and peers in the same market, these can indicate an average. However, the stage where the startup is in, its unique value proposition, whether it’s received financing before or not, whether it’s revenue-generating or not, the sector’s profitability and margins along with other factors play a role in the valuation process.
Stride Financial Advisors
For example, a startup that’s operational and generating revenues is likely to use a combination of the DCF and the Multiples Valuation methods.
It’s therefore important that startup founders don’t cling to certain valuation methods over others or over valuations in general.
After all, the goal is to get enough funding to help the business grow and achieve its targets.
The location or region of the startup plays a role in how much it can raise.
For example, and you’ve probably already noticed this, startups in the United States tend to get larger funding rounds compared to MENA-based startups.
This is even sometimes applicable to startups operating in the same region. In many cases, you’ll notice that startups in the UAE and Saudi Arabia are often able to raise more funding than those in Egypt.
That said, every startup comes with its needs and requirements. And the local currency along with local economic dynamics play a role in how much funding a startup needs.
Wrapping it up
Determining the precise value of a startup isn’t easy.
Every startup is different. And there are many factors at play such as industry, sector, geographical location, and the startup’s stage – just to name a few.
Not to mention, how the startup’s founders operate and manage their business plays a role in the startup’s success and its ability to raise funding.
But the important thing to remember is this:
There’s no single startup valuation method that’s the best or that’s the most accurate or that’s a-must. All methods, eventually, rely on estimates and forecasts.
And while some valuation methods may be popular, there’s no rule that says one method is better than the other.
That’s why using several startup valuation methods is the best option for any startup looking for funding.
If you need help evaluating your startup, then get in touch with the Stride Financial Advisors team and we’ll help you and your business by conducting those valuation methods.
Stride Financial Advisors provides various startup services including valuation forecasts, investor pitch decks, financial and cash flow planning, and others.
