Before You Dive In:
- Valuing startups can be far more difficult than valuing established businesses
- There are many methods for valuing startups and you should consider using multiple methods
- Both investors and startup owners need to be able to properly value new companies
How to value a startup?
There are multiple methods of valuing startup companies, each with pros and cons.
Names for angel investor Dave Berkus, this method uses qualitative and quantitative factors to determine a startup’s value. They are:
- Soundness of idea
- Management team quality
- Strategic relationships
- Product sales and rollout
You must assign a financial value to each of these factors to determine the total valuation of the business.
The Scorecard method of valuing startups compares the startup to other similar startups that have recently received funding. For example, you might compare the startup to another in categories like:
- Quality of management
- Market size
- Quality of product or technology
- Need for additional financing
Weight each category according to your desires and see how the startup stacks up against the competition. You can then use the competition’s valuations to determine the value of your startup. For example, if a similar startup was valued at $2 million and yours compares favorably, yours might be worth more than $2 million.
Venture Capital method
This method relies on the investors desired rate of return based on their perceived risk of investing in the company. To use this method, investors must:
- Estimate the investment required
- Forecast the startup’s future financials
- Determine when they’ll exit the position
- Estimate the value at exit
- Determine the desired rate of return
- Calculate the valuation based on required investment, time to exit, value at exit, and rate of return
The Risk-Factor Summation method
This method starts with estimating your company’s value based on the valuations of similar startups. Then, you adjust for the risks that your company faces compared to the competition. If you face less risk, your company is worth more. If you face more risk, yours will be worth less than other businesses.
This method of valuing a startup relies on estimating the cost to create an exact copy of the startup from scratch. The more it would cost to rebuild your business from the ground up, the most valuable your company is.
Discounted Cash Flow method
This method relies on being able to forecast future cash flows from the startup.
The formula for Discounted Cash Flow (DCF) is:
DCF = (cash flow in year 1 / (1 + discount rate))1 + (cash flow in year 2 / (1 + discount rate)) 2 + (cash flow in year 3 / (1 + discount rate))3 …
Combo Platter method
The combo platter method, as its name implies, combines many other valuation methods, including others on this list. For example, it can combine aspects of the Berkus, scorecard, and risk-factor summation methods.
The idea is that by using multiple valuation methods you can arrive at a more accurate value for a company. However, it can be difficult to determine which aspects of each method to use.
Asset-Based Valuation method
Asset-Based valuation looks at a startup’s net asset value, which is the company’s assets minus liabilities. The idea is that a company must be worth at least as much as what it owns is worth, minus any liabilities it has.
For example, a startup that owns a $500,000 piece of machinery with no liabilities must be worth at least $500,000 because it could sell the machine for that much cash.
How is valuation calculated?
The truth of valuation is that it is largely subjective, especially for startups. Investors and business owners have to decide what is important to them and how much they’re willing to pay.
Of course, fundamentals like the company’s current level of sales and the size of its potential market are important. Companies with more revenue and larger markets will be worth more. However, subjective factors, like the quality of the business’s management team also play an important role in the company’s success. Those are much harder to value.
What are some factors to consider during pre-revenue startup valuation
Some key factors to consider during a startup’s pre-revenue valuation are:
- Traction. Has the startup already found some success or a test market and begun selling products?
- Value of a Founding Team. A good founding team can help propel a business to success. Does management seem competent, and do they have experience with startups?
- Prototypes. A startup that has a proof of concept or minimum viable product will be worth more than one with only a business idea.
- Supply and demand. Is there a large market for the company’s products and an adequate supply of raw materials to meet that demand? High demand and adequate supply are essential.
- Emerging industries/trends. Companies on the cutting edge of industry or appealing to new trends may be worth more.
- High margins. The higher the margin on a product, the more profitable a startup can be.
How to value startup equity?
When valuing startup equity compared to established businesses, keep these tips in mind.
- Consider growth potential. Startups are smaller than established businesses, but they can grow quickly. While fundamentals like revenue might indicate an incredibly low value, you might have to pay more for potential growth.
- Keep risk in mind. Don’t overvalue startups. Many will fail, so you want to account for that risk.
- No profits may not be a bad thing. If you’re investing in an older startup, keep in mind that a lack of profit isn’t always a bad thing. The business might be reinvesting in itself to grow. With established businesses, profits are essential.
- Reputation matters. The reputation of a startup’s management is essential when determining its value. A strong management team, especially one with a history of success with startups, can boost valuations.
What's the difference between startup valuation and mature business valuation?
When thinking about how you value startups and established companies, there are a few things to consider.
For example, if you invest in an established business, you’re likely buying a very small share and will have little say in how it operates. Investing in a startup can give you significant equity and you might be able to help guide its future actions.
With established businesses, you typically expect steady, growing profits. Startups often run at a loss for years, so you need to base valuations on growth potential more than on current profits.
Startups also tend to have much smaller management groups than established companies. That means the quality of each individual involved in the startup is more important and can have a real impact on the company’s value. With established businesses, the reputation and skill of each employee or manager is less important.
How do you value a startup without revenue?
Many startups go through their first round of funding before they start producing revenue. That can make it difficult to value them using traditional methods, such as discounted cash flows.
Instead, you have to use other methods, such as the Berkus method or the cost-to-duplicate method. Consider factors such as the size of the startup's markets and its future potential for revenue to arrive at a fair valuation.
What are some common mistakes when valuing a startup and how to avoid them
Some common mistakes when valuing startups are:
- Unrealistic expectations. Valuing startups relies in no small part on predicting their future performance and growth. Make sure your predictions are reasonable and that you aren’t expecting a tiny company to explode into a $1 trillion business in six months.
- Expecting a single number. Valuing businesses is an art and science. If you ask five experts to value the same company, you can expect five different answers. Be ready to get a range of valuations from potential investors.
- Blindly relying on comparable companies. Using the values of similar startups as a starting point to value a different business is a good idea. However, blindly relying on those comparables can cause issues. No two startups are exactly the same, so you need to account for differences such as management team and other factors.
Business Mentoring Organizations That Could Help
If you’re running a startup, it can be useful to have a mentor that can guide you as you grow the business. Here are some good places to find mentorship opportunities.
- SCORE. This nonprofit organization has more than 300 groups across the country.
- Local networking events. Many areas have business groups or organizations that run networking events where business owners can meet each other. These can be a great way to find a mentor.
- Women’s Business Centers. Women business owners can use these groups to connect with like-minded women and are a good place to find others who can help them through difficult decisions.
- Small Business Development Centers. The government offers a database where you can find these centers. Most have some form of mentoring program.
Startup owners might also like to consider applying for additional funding to grow their new companies and strengthen their estimated value. If you'd like to learn more about business loan options dedicated to startups, visit our other article.