4 Best Ways to Calculate Valuation of a Startup - with CALCULATOR

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: 


Source: Seed Stage Capital

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 financeFuture 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. 

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Thinking with the head of an investor

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:

  1. The degree of product differentiation of an industry is positively related to the valuation of new ventures in this industry. Product differentiation refers to the process of distinguishing your product or service from others in the market, to make it more attractive, for example by advertising your product.
  2. The growth rate of an industry is positively related to the valuation of new ventures in this industry. Industry growth is usually rapid in the early stages of the industry life cycle.  Industries in the early stages of development provide an opportunity for new entrants to capture the new demand in markets. Also, if you enter a relatively new market, it is also less likely to be revenged by competitors, who have entered the given market before.
  3. A new venture is valued higher if its founder has relevant industry experiences before founding the venture. It refers to the number of years the entrepreneur has worked in a similar industry. Similarly, another report found that growth firms tend to be led by entrepreneurs who began their venture based on ideas developed in their previous jobs.
  4. A new venture is valued higher if its founder has previous top management experiences. If the founder has skills and experience in managing people, who are on different levels of the organization, it means that he knows the necessary strategies and organizational structures to grow the tiny new venture to a larger size that requires more sophisticated management infrastructures to support.
  5. A new venture is valued higher if its founder has previous startup or entrepreneurial experiences. It indicates a set of entrepreneurial skills, contacts, network and business reputation.
  6. New ventures founded by a team of founders are valued higher than those founded by one founder. It seems that it is more difficult to survive if the startup is a ‘one-man’ show, as no one can have all the necessary skills and knowledge to effectively compete. More founders means that there are more people available to do the enormous job of starting a new firm and that there is more opportunity for specialization in decision making.
  7. New ventures with a complete management team are valued higher than those without one. One of the important aspects is the balanced management team in place. A complete management team not only carries more credibility and enhances the chance of success, but also saves time for potential investors.
  8. The network size of a new venture is positively related to its valuation by venture capitalists. The network size refers to the resources that can be accessed at the level of the entrepreneur, which can be a strategic alliance with other business firms. 

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. 

1. Venture capital valuation method

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. 

  • Pre-money valuation is the company’s value before it receives outside investment
  • Post-money valuation is the company’s value after it receives a round of financing.

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

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2. Berkus method 

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. 

Dave Berkus (Source: berkus.com)


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).

Description: 

  • Sound Idea (basic value)

 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).

  1. The business model is not clear. Product, customers, market fit do not resonate with each other
  2. The business model should be improved.  Targeting, segmentation not developed yet, feasibility study of business processes should be improved 
  3. The business model is reliable. Key business resources: physical, human, intellectual, and financial resources are clear and value proposition identified. 
  4. The business model has potential. The business model resonates with the company goals and has the potential to be established 
  5. The business model is strong. The business model is profitable, innovative, and can be scaled. Revenue Streams are established and can be expanded 
  • Prototype (reducing  technology risk)

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. 

  • Quality Management Team (reducing execution risk)

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

  1. Team is not full. Team is incomplete and the responsibility of its members are not clear
  2. Team needs experience. The founders lack the academic background and have less or no practical experience in the field
  3. Team is reliable. The responsibilities of its members are set. Previously, the CEO possessed management positions in the big corporate environment.
  4. Team is adequate. The team is led by one or more founders that have high qualification, have experience of managing teams in a corporate environment or in startups
  5. Team is brilliant. Team with highly skilled members, each having outstanding records in elite universities and/or in entrepreneurship, team management, corporate environments. They brilliantly understand and cooperate with each other and established productive relationships. 
  • Strategic relationships (reducing market risk)

This is majorly concerned with the market associated with product or service, risks, etc.

  1. No strategic relationships. Strategic relationships are not established
  2. Start of strategic relationships. A number of strategic relationships are started to be established with big corporates or institutions 
  3. Strategic relationships set. The first agreements are signed 
  4. Quality strategic relationships set. Several strategic relationships are established with well-known corporations
  5. Strong strategic relationships. Multiple strategic relationships are established with well-known corporations
  • Product Rollout or Sales (reducing production risk)

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.

  1. No customers. There are no customers. 
  2. Some customers. There are few customers who buy infrequently, low sales
  3. Several customers. The number of customers who are making the purchase regularly is increasing, the startup is acquiring new customers, the startup is strengthening its customer acquisition strategy 
  4. A sufficient number of customers. The number of customers is increasing significantly, high sales
  5. Many customers. The startup has  loyal customers who are willing to pay for unique offerings and its customer retention plan is strengthening 

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).

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3. Scorecard Valuation Methodology

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). 

Bill Payne (Source: angelresourceinstitute.orgÖ


Steps of Scorecard Valuation Methodology

  1. The first step of the valuation is to calculate the mean of the pre-money value of pre-revenue companies in the region in the given industry. (Pre-money value is the value of a startup just before investment.) For example, if the average Pre-Seed Deal is $4 million and the average Seed Stage Deal is $5 million in the given region, then the mean of the pre-money value is $4,5 million. This is the starting point for further calculations. 
  2. The second step aims to compare the target company to your perception of similar businesses in your region. The following factors need to be considered:
  • Strength of the Management Team - 0-30%
  • Size of the Opportunity - 0-25 %
  • Product/Technology - 0-15%
  • Competitive Environment - 0-10%
  • Marketing/Sales Channels/Partnerships - 0-10%
  • Need for Additional Investment - 0-5%
  • Other - 0-5%

Each factor gets a weight and the sum of the weights shall be 100%.

  1. The third step is to evaluate your target company along these factors. Compare your target company to the regional average and give a weight to your target company based on its strengths and weaknesses. For example, if you have a strong team, add 125% to Strength of Entrepreneur and Team factor. If the market is competitive, add 75% to the competitive environment. Then multiply it by the regional weights and you get a factor weight that is valid to your target company.
An example for pre-money valuation


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)

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4. Cost-to-duplicate method

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:

  1. Research expenses: researching the industry you try to enter is important and business owners can decide to hire a market research firm to help them assess the market. 
  2. Cost of loans: Loans are available for small businesses from banks and saving institutions. The loans are accompanied by interest payments, which must be planned as a cost.
  3. License, permit fees: Some businesses need to count on industry-specific permits, which can have costs. 
  4. Technological expenses: Technological expenses include the cost of a website, information systems, and software, including accounting and payroll software, for a business. Some small business owners choose to outsource these functions to other companies to save on payroll and benefits.
  5. Equipment and supplies: Either you lease or buy the equipments, the cost of them is relevant. 
  6. Advertising and promotion: Cost of marketing, such as advertisement cost or the cost of hiring a marketing agency.
  7. Human resources: The cost of labor, such as salaries, taxes, insurance. 

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.

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Summary

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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