Lions Financial helps Financial Institutions and Businesses, together with their tax and legal advisors, during the Due Diligence and Valuation period to make the optimal financial decisions for success. We have compiled a brief overview of What are the Methods for Valuing a Startup for Venture Capital Financing.
The issue with startup valuations is that they rely on guesswork and estimations, meaning that there is no single, universally accepted analytical methodology for investors. Instead, Venture Capitals will draw upon several venture capital valuation methods to understand the value of a startup.
The use of such valuation methods is dependent upon the stage of a business, and the corresponding data points available in the market and/or industry the startup operates in. The common methods are:
- Cost-to-Duplicate Method
- Scorecard Valuation Method
- Dave Berkus Valuation Method
- The Risk-Factor Summation Method
- Venture Capital Valuation Method
- Discounted Cash Flow method (DCF)
- Valuation by Multiples Method
This startup valuation method requires some heavy due diligence, as its main goal is to determine how much it would cost to start the same business from scratch. The cost-to-duplicate method is a very realistic approach that puts into question the competitive advantages of a startup. If the cost of duplicating the startup is extremely low, then its value will be next to nothing. In turn, if it is costly and complex to replicate the business model, then the value of the startup will increase as the difficulty increases.
The Scorecard valuation method compares the target startup company to other funded startups and modifies the average valuation. Such comparisons can only be made for companies at the same stage of development.
- Determine the average pre-money valuation for pre-revenue startups in the specific industry and location.
- Compare the target startup to the average pre-money valuation in step 1 and assign a value for each criterion.
Considering the following:
- Strength of the management team: founders’ experience and skill set, founders’ flexibility, and completeness of the management team.
- Size of the opportunity: market size for the company’s product or service, the timeline for increase (or generation) of revenues, and the strength of competition.
- Product or service: product/market definition and fit, the path to acceptance, and barriers to entry.
- The sales channel, stage of business, size of the investment round, need for financing, and quality of business plan and presentation.
Step 3: Calculate the percentage weights to get the total estimated value. You assign a percentage weight to each criterion based on companies’ consideration and multiply it by the value you had in step 2 to get a weighted value. Then you sum up the weighted values to get the total value estimation.
You start with a pre-money valuation of zero, then assess the quality of the target company considering the following characteristics, and add up the value to get a pre-money valuation. This method was created specifically for the earliest-stage investments to find a starting point without relying upon the founder’s financial forecasts.
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
This method combines aspects of the Scorecard Method and the Berkus Method to provide a more-detailed estimation focused on the risks involved with an investment.
Step 1: Like the Scorecard Valuation Method, you start with an average valuation for your company based on similar companies in the industry and region
Step 2: Address a list of risks associated with the startup and its industry. It takes the following risks into consideration:
- Stage of the business
- Funding/capital risk
- Manufacturing risk
- Technology risk
- Sales and marketing risk
- Competition risk
- Legislation/political risk
- Litigation risk
- International risk
- Reputation risk
Step 3: Instead of assigning percentage weights, we assign the following ratings to each risk factor and do an adjustment to the average pre-money valuation per each rating:
Each of these risk areas will be scored as follows:
- -2 – very negative for growing the company and carrying out a successful exit
- -1 – negative for growing the company and carrying out a successful exit
- 0 – neutral
- +1 – positive for growing the company and carrying out a successful exit
- +2 – very positive for growing the startup and carrying out a successful exit
This technique is well-suited when examining the risks that need to manage to make a successful exit, and it can be paired with the Scorecard Method to give a holistic overview of the startup’s valuation.
The venture-Capital method backs into a pre-money valuation by assuming a minimum required rate of return necessary (using industry standards or fund benchmarks) and estimates the exit year revenue and multiple to create a valuation.
The Venture Capital Method has 2 steps:
Step 1: Calculate the terminal value of the business in the harvest year.
Step 2: Track backward with the expected ROI and investment amount to calculate the pre-money valuation.
Terminal value is the expected value of the startup on a specific date in the future, while the harvest year is the year that an investor will exit the startup. The Industry P/E ratio is the stock price-to-earnings ratio.
Calculating the terminal value
Find the following figures:
- Projected revenue in the harvest year
- Projected profit margin in the harvest year
- Industry P/E ratio
The industry average for the P/E ratio and projected profit margins are to be found through industry research
- Terminal Value = projected revenue * projected margin * P/E
- Terminal Value = Earnings * P/E
Calculating the pre-money valuation
Step 1: Find the following figures:
- Required return on investment (ROI)
- Investment amount
Step 2: Perform calculations:
- Pre-Money Valuation = Terminal value / ROI – Investment amount
The discounted cash flow method determines the value of a business by estimating its future cash flows, discounting them at a certain discount rate to obtain their present value. The sum of these discounted cash flows will be the resulting valuation for the startup. Since this method relies heavily on assumptions that require some historical data to be performed, it is not the most widely employed to value startups.
The multiples method values a company based on its EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization). Depending on the industry, competition, management team, and some other qualitative aspects, you can value the business at 5X, 10X or 15X of current EBITDA. This is a powerful and simple valuation tool that investors employ to quickly estimate the value of a more mature startup.
Startups have different stages they go through from the moment the idea comes up until the point at which the company has matured to a fully-operational corporation. Each of these startup valuation methods can be more useful for some stages than others and you need to determine in which stage the company is in before you pick the method that is best suited for the company.
It is the earliest of the stages for startups. At this point, there’s usually no revenue, no assets, no team, no business. Just an idea and the willingness to move forward. At this point, the Berkus Method or even the Venture Capital Valuation Method may be the most recommended.
The startup is now a solid idea on the move. It probably has a beta product or a prototype by now or has already made some sales. At this point, you can rely on more technical methods such as the Cost-to-Duplicate method, and the Venture Capital Method.
At this point, the startups need money to expand and continue growing. The business model is already proven (to some extent) by now, and revenue-generation potential can be assessed. You can incorporate startup valuation models that rely heavily on financial data to come up with a number, such as DCF Method and the Valuation by Multiples Method.
These methods are not mutually exclusive and can be used in combination to arrive at a more accurate valuation. However, it is important to keep in mind that valuing a startup is not an exact science, and the actual value may differ from the estimated value due to various factors, including market conditions and future events.
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