Fanni Kiss, Abduvosid Malikov, CEU iLab
July 24, 2020
It is essential for entrepreneurs to put a value on their companies so that they know how much equity to give up, to seek equity investment. When entrepreneurs begin to seek investment, most investors expect to see an approximate valuation of the business. That is where startup valuation methods come into play.
Before we dive into valuation techniques, it is important for entrepreneurs to know in which stage their startup is. Depending on the stage of the startup, the founders can expect lower or higher offers from the investors. An adequate overview was given by seedstagecapital in this table:
If you’re in one of the early stages, the business valuation might be challenging, as sales have not started yet. The economic value of any investment is the present value of its future cash flows, as Brealy, Myers, and Allen state in the Principles of corporate finance. Future cash flow is the sum of cash (or cash-equivalent) payments that the company receives or gives in the future. However, this mainstream finance theory is less applicable for valuing early-stage businesses. Both venture capitalists and entrepreneurs are struggling with the high variance of valuations calculated from the extant methods for exactly the same entrepreneurship. In the next, we’ll take the relevant resources in order to give a comprehensive picture of the startup valuation aspects and methods.
An empirical research by Tarek Miloud, Arild Aspelund and Mathieu Cabrol examined what factors are taken into account by venture capitalists, when they evaluate a new venture. The empirical research has developed an integrated framework to study new venture valuation by venture capitalists and identified eight factors, which are positively related to the valuation of a new venture according to empirical models:
The eight different aspects mentioned above are important to keep in mind, they can help a startup founder to think with an investor’s head. These factors come from management frameworks and it is difficult (or impossible) to give a numeric value to each factor. Now, we can turn to more accurate methodologies and talk about numbers.
The venture capital method is suitable for you if your startup has not achieved any revenues yet. In this method, first we should get familiar with some terminology.
When startup owners approach investors saying “We are asking for $150,000 for 10% of the company”, they mean “We are asking for INVESTMENT for SHARE of the company.”
In this example, the entrepreneur is asking for $150,000 for 10% of the company, which means that the post-money valuation is $1.5 million
$150,000 / .10 = $1.5M
The pre-money valuation is simply the post-money valuation less the investment. In this case, $1.35M
$1.5M–$150K = $1.35M
The Berkus Method is a way to value early-stage companies, especially those in technology, developed by American angel investor Dave Berkus in the mid-1990s.
According to the author, fewer than one in a thousand start-ups meet or exceed their projected revenues in the periods planned. Therefore one needs some reliable valuation metrics as a predictor of the future.
Dave suggests that the best way to value a start-up is to give value to those elements of progress by the entrepreneur or team that reduce the risk of success. Investors should believe that the candidate company, if successful, could achieve some level of gross revenue at the end of the fifth year in business. It is estimated at approximately $20 million.
Now let’s see how this method works. The Berkus Method assigns a number, a financial valuation, to each of four major elements of risk faced by all young companies – after crediting the entrepreneur some basic value for the quality and potential of the idea itself. This method adds $500,000 in value for each of the following risk-reduction elements:
For example, the $500,000 maximum value yields a maximum pre-money enterprise valuation of $2.5 million when all elements are “perfect” for a target in the eyes of the investor.
Investors try to keep start-up valuations at a low enough amount because they take extreme risks. Also, they aim to provide some opportunity for the investment to achieve a ten-times increase in value over its life. Once a company is in revenues, the Method is no longer applicable, as everyone will use actual revenues to project value over time.
As you can see, the Berkus Method prioritizes the reduction of risk, adding value for each element a startup has that can reduce risk and increase the chance that a buyer will get a good return on their investment. Note that you can assign partial value, for example, 250,000 instead of 500,000 (Northstarib.com).
What is the value of your idea on which the entire business will be running? What about the value proposition? A sound idea that has enormous potential for growth plays a key role in calculating this quantitative measure (Finology).
Now let’s assess the prototype of your startup. While determining the valuation of your startup, you should see how efficient your prototype is, how well it uses technology to meet its end needs, etc. For example, if you completed 50% of the work on a prototype, then you can add $250,000 of value.
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.
“In building a business, the quality of the team is paramount to success. A great team will fix early product flaws, but the reverse is not true.” Bill Payne
This is majorly concerned with the market associated with product or service, risks, etc.
How will you be reaching the end customers? How are you planning to deal with the supply chain? Answer these valuation questions in this stage.
The principal shortcoming of this method is that the methods are not derived from financial theory or fundamentals. This means that assessing progress in each of the key qualitative factors and translating that assessment into monetary value requires strong personal judgment. With respect to the Berkus Method, not only is further judgment required to assess whether the business will achieve sales of at least USD$20 million in five years but it also imposes an upper ceiling on value which may not be appropriate. For these reasons, scoring methods are perhaps most suited for pre-revenue companies at the seed funding stage. They become less useful as the target company matures and the track record of the business is more established (FTI Consulting).
This is also known as the Benchmark Method or the Bill Payne Method. It is applicable for pre-seed and seed stage opportunities, except those with very high capital requirements prior to achieving first revenues (such as some life science and energy deals).
Steps of Scorecard Valuation Methodology
Each factor gets a weight and the sum of the weights shall be 100%.
4. Multiply the sum of factor weights by the mean of the pre-money-value and you get the pre-money valuation for your target company. In this example: $4,5 million x 1,155 = $5,2 million.
Bill Payne, the inventor of the Scorecard Valuation Method, has written a post on the Angel Capital Association’s blog about the methodology and the worksheet is available here to help you in the evaluation. (Angel Insights Blog, 2019)
The main goal of the cost-to-duplicate startup valuation method is to find out how much it would cost to start the same business from scratch. A good starting point to evaluate costs is to create a business plan, which forces you to target and estimate a financial plan for the first year.
Seven common business startup costs:
In case the cost of duplicating the startup is very low, then the value will be minimal. In turn, if it is complex and costly to replicate the business idea and model, then with the difficulty increase the value of the startup will increase as well.
If your aim is to valuate your startup, but your business is at an early stage, you might have faced with some difficulties. How to valuate a venture, which does not have sales or costs yet? This article can help you to evaluate your entrepreneurship based on the five startup valuation methods provided above.
It is important to note that the methodologies are based on your perceptions, which can be biased or based on wrong assumptions. Thus, the results are also subjective. It can help, if you open up an excel and list your assumptions and show them to someone, who is familiar with the startup ecosystem. This can help to make a reproducible computation methodology, and easier to make corrections later.
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