There are many different methods used in deciding on a startup's valuation, while all of them differ in some way, they are all good to use.
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.
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 20X and they need $100,000 to get a positive cash flow we can do the following calculations.
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:
If Exists: | Add to Company Value up to: |
Sound Idea (basic value) | $1/2 million |
Prototype (reducing technology risk) | $1/2 million |
Quality Management Team (reducing execution risk) | $1/2 million |
Strategic relationships (reducing market risk) | $1/2 million |
Product Rollout or Sales (reducing production risk) | $1/2 million |
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
* 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 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,
Each element is assessed as follows:
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).
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.
For example if you wanted to find the cost-to-duplicate a software business, you would look at the labour cost for programmers and the amount of programming time that has been used to design the software.
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
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.
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:
Startups with just a business plan will receive a small valuation, but that will increase as they meet developmental milestones.
This method is to literally look at the implied valuations of other similar startups, factoring in other ratios and multipliers for things that may not be similar between the two businesses.
For example, if Startup A is acquired for $7,500,000, and its website had 250,000 active users, you can estimate a valuation between the price of the startup and the number of users, which is $30/user.
Startup B might have 125,000 users which would then allow it to use the same multiple of $30/user to reach a valuation of $3,750,000
This method is based solely on the net worth of the company. i.e. the tangible assets of the company. This doesn't take into account any form of growth or revenue, and is usually only applied when a startup is going out of business.
This method factors in the possibility of a startup really taking off, or really going badly. To do this it gives a business owner three different valuations
Whilst it is helpful to have a valuation of a startup in order to help investors offer the right amount of money needed it isn't necessarily the dominant reason why an investor will invest in a startup.
Quite often convincing an investor that a startup has value is more about negotiating, convincing and being passionate and bold about the business idea. Whilst there's no concrete evidence of a startup valuation there is evidence that you, as a business owner will do everything you can to make the business work.
As a result investors will sometimes invest in people rather than the business idea
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.
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.
Pay as you go – a startup would only raise money that it needs, spending as little as possible whilst aiming for steady growth
When it comes down to it, a startup is worth what an investor is willing to invest. A startup business owner might disagree with an investor's valuation because their own valuation is different.
But as these valuations are based on predictions a startup owner should not assume that the value is permanent or right.
Business valuation is never straightforward for any company. It is constantly changing and there are so many factors. For a startup this is even truer because there's nothing to go on.
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.
If you need help with raising venture capital or with your startup valuation 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.