What Is Start-Up Valuation?
Startup Company Valuation is the process of evaluating the worth of the startup using some startup company registration methods. The valuation process holds importance for startups and entrepreneurs as it helps determine the fair amount of equity they have to give to an investor in exchange for funds. The process holds the same importance for investors as they need to know what percentage of shares they will receive in return for the amount they have invested.
In this article, Team YLCC brings you an overview on how valuation works for a start-up. Read on!
- Startup’s Reputation
A positive image of the company is important for an entrepreneur to survive and grow in the market. The reputation of your startup is one of the most important aspects an investor looks at before investing.
So, make sure whatever thing your startup offers has positive reviews in the market. Before proceeding ahead with the round of valuation, founders need to ensure a positive impact of their startup in the market.
- Traction
Traction refers to the progress your company has made or the momentum your company has attained over a period, keeping in mind its potential customers.
It provides quantitative proof of customer demand and shows that your startup is progressing in the right direction.
- Prototype/MVP
If you just starting, make sure to develop a prototype. A prototype plays a key role and can influence the decision of an investor. Have a prototype or a minimum viable product ready before evaluating your startup.
- The Industry
The industry to which your startup belongs plays a key role in deciding in fair company valuation of your startup. If the startup belongs to a sunrise industry, investors will likely pay a premium. That is why it is important to choose the right sector, as it will influence the valuation of your startup.
Some other factors like pre-valuation revenues, market size, distribution channels, competitors, etc., play a major role in deciding the fair value of a startup. For Instance: If your product is only suitable for people living in Delhi, the company valuation will be lower than if your potential market is India or globally.
Now that we know the basics of start-up valuation, let us understand some methods through which valuation of a start-up can be calculated.
Berkus Method
First on our list will be the Berkus approach, which is otherwise known as the “stage development method or the development stage valuation method”. It was first put forth by a US-based Venture Capitalist, David Berkus, to calculate the valuation of the startups. This method utilizes five key metrics for making the right calculation regarding the worth of the startup. Those metrics include:
- Basic Value – This is essentially arrived at by valuing the idea on which the entire business will be running. A sound idea that has enormous potential for growth plays a key role in calculating this quantitative measure. A company can add up to $ 500,000 to its worth when calculating this factor.
- Technology – Here, the focus ultimately lays on the prototype the company or startup holds. While determining the valuation of the startup under this head, the company should see how efficient it is, how well it uses technology to meet its end needs, etc. $500,000 will be the maximum limit to value a startup.
- Execution – No matter how big your ideas or dreams are, the quality of management can either be a deal maker or breaker. Hence, under this head, you will be allotted a maximum of $500,000 to the type of management and how effective they are in executing the tasks.
- Strategic Relationships In The Core Market – This is majorly concerned with the market associated with product or service, risks, etc. The limit remains the same for this head as well.
- Production And Consequent Sales – How you will be reaching the end customers and how you are planning to deal with the supply chain answers the valuation question in this stage.
Though the Berkus Method is seen as an important method utilized by many startups, it fails to take into consideration a lot of other aspects of startup life. However, for a startup that is in the early stage of its life with no revenue generation, this might be an ideal way to arrive at the valuation.
Risk Factor Summation Method
Unlike the Berkus method, where startup company valuation is done using only five key criteria, the Risk Factor Summation Method (RFS method) considers a wide range of criteria to reach the pre-money valuation.
In this method, the initial value of the startup is determined by assessing similar startups. After that, risk factors are factored in this value as multiples of $250K. These multiple risk factors range from a low-risk value of $500k to a high-risk value of -$550k, i.e. a value is added or subtracted to the initial value as per the risk involved.
Different Risks That This Method Considers Are:
- Stage Of The Business
- Manufacturing Risk
- Sales And Marketing Risk
- Management
- Reputation Risk
- Technology Risk
- Competition Risk
- International Risk
- Legislation/Political Risk
- Litigation Risk
- Funding/Capital Raising Risk
- A Potentially Profitable Exit
Cost-to-Duplicate Approach
This is another popular method. Through this, a start-up owner would calculate the expenses which will be incurred to recreate the entire business. For this, all the physical assets, spending for research and development and any other expenses that have been incurred in the process will be included. Though this seems to be a good way of calculating the startups’ valuation, it’s not free from drawbacks. Some of them are as follows:
- It does not take into account the valuation of intangible assets. Certain aspects like the brand name, goodwill plays a crucial role in any business. They might make a business great or simply destroy it. Hence ignoring the qualitative value of the same will make your valuation figure misleading.
- Future potential is an important parameter to any business, big or small. Thus, avoiding them in arriving at your valuation might act as a hindrance in arriving at the right figure.
- Other key factors, like customer engagement, are also excluded.
Venture Capitalist Method
Venture Capitalist Method is majorly used by venture capitalist looking for making investments in start-up companies. Let us take an example: Suppose a Venture Capitalist (VC) is willing to make investment of $1 million in a start-up technology company for a period of five years. The company is presumed to be earning $2 Million. Net Profits in year 5 and the company comparable are fetching a price earning (PE) multiple of 10x and the VC requires a 20 percent return on its investment. The critical question is how much equity stake the VC should need to get for its investment.
First Chicago Method
The value of Startup in this method is determined using Comparable Companies Multiples (based on Existing or Exit year financial metrics). First Chicago approach then takes into consideration three business scenarios: Success, Failure and Survival case and associate probability to each case based on the stage of business and qualitative metrics to arrive at the weighted average value. To conclude, Start-up valuation depends a lot on judgment and qualitative factors like Founders and Co-Founders background, experience and passion, Biz Model, Scalability potential of business (with or without technology), Competitive landscape, Current Traction. Startup’s often operating in the valley of death which requires considering the probability of their success and failure. In a way, Start-up valuation also involves validation of business model which makes it complicated vis-vis other valuations. As everything is future driven in start-up, the experience of valuer plays a significant role in value conclusion.
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to the decisions of investors in companies or securities, such as acquiring a company or buying a stock, and for business owners and managers looking to make capital budgeting or operating expenditures decisions.
- Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.
- The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF.
- If the DCF is above the current cost of the investment, the opportunity could result in positive returns.
- Companies typically use the weighted average cost of capital (WACC) for the discount rate, because it takes into consideration the rate of return expected by shareholders.
- The DCF has limitations, primarily in that it relies on estimations of future cash flows, which could prove inaccurate.
Valuations are important for both start-ups and investors, but valuations are nothing more than formalized guesstimates. They are just a good starting point when considering fundraising. Valuation never shows the exact value of your start-up. So, one should never use a single approach to calculate startup valuation. To have a more accurate valuation, one may use multiple methods.
