5 Best Ways to Calculate Valuation of a Startup

Aliia Munduzbaeeva, CEU, MA in Economics

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.  

How Can Entrepreneurs Value Their Companies?

Entrepreneurs can use several tools to determine how much their company is worth. Typically, the value of their company is based on the firm`s potential in their chosen market.  

The easiest way is:

to check out similar companies operating in the same industry to see how they are being valued.

Sites such as BizBuySell and BizQuest will help you to find out how businesses are worth in your industry and how much they have been valued and when they have reached profitability. Another thing you can do is to seek advice from lawyers and accountants who can help to determine the market rates for companies like yours.  

But how do you value a company which does not have any financial history?

The valuation of the early-stage company is based on the anticipation of future growth. To make an estimation, you will have to answer the following questions:

  • How much time will it take for the startup to become profitable?
  • What potential for growth does it have?
  • How can you prove to investors that your company is worth investing in?
  • How investors might realize a return on their investment?

How do investors value a startup?

The most frequently asked question at any startup event is “how to value a startup?”. The market and industry or sector in which it operates play the biggest role in determining the value of your startup.  

Investors will want to know your experience and your team`s past successes. They will also want to see how many people use your product or service. Even if your startup is not currently profitable, showing that you have 100,000 users, for example, proves to the investor that you have a potentially scalable business if provided with the appropriate amount of funding.  

There are many tools and methods to value an early-stage business. Their purpose varies from small business to large public companies. Furthermore, they vary depending on how many assumptions should be made based on the company`s future and past financial performance.  

It is easier to value an established company that has been operating in the market for several years. But as most of the startups do not have concrete values for annual profit, interest, or taxes, etc. the vast majority of startup valuation methods are based on estimations, forecasts, field research, and intuition. Startup valuation is based on less concrete qualifications and quantities, like supply and demand, industry-specific factors, products, and competitions.  

How to choose a right startup valuation method?

Different startup valuation methods underline different aspects of the company. It is easy to choose your appropriate startup valuation method if you know what are your company`s strengths and areas that should be improved.  

You can start valuing your startup by choosing the suitable valuation method from the list of most popular startup valuation methods.  

Venture capital valuation method

The venture capital method is suitable for you if your startup has not achieved any revenues yet. Calculating a valuation with the venture capital method involves many assumptions. A startup valuation that employs a forecasted terminal value for the startup and an expected return from the investor.

The Venture Capital Method’s formula is:

Pre-Money Valuation = Post Money Valuation — Invested Capital

With the Post-Money Valuation being the terminal value divided by the expected return.

Let us say an investor values your startup at a terminal value of $1,000,000 and he wants a 20X return on his $10,000 investment. In this case, your Post-Money valuation would be $50,000. And, according to the Venture Capital Method, the Pre-Money Valuation would be:

Pre-Money = $50,000 — $10,000 = $40,000

Berkus method

A method that values businesses based on several key aspects, giving each aspect a certain sum of money.

Qualitative elements to be considered as value:

  • Sound Idea
  • Prototype
  • High-Quality Management Team
  • Strategic Relationships
  • Product Rollout or Sales Made

For each aspect, the startup possesses entirely, the valuation should go up by $500,000. However, depending on the level in which each feature is developed the investor could reduce the value of the item to say $400,000 or $250,000, to determine the final value.

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. 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.

Discounted Cash Flow Model (DCF)

DCF model - a widely used valuation method, to calculate the value of a startup or business in general. The value is calculated based on estimated future cash flows, which should be discounted at a certain discount rate, which helps to obtain the present value. If we add up all these discounted cash flows, as a result, we will get the value for the startup.   This method requires some historical data on financial performance, still, it heavily relies on assumptions about future performance.  

Valuation by multiples method

If a startup is already achieving some revenues, valuation by multiples method is one of the most used.    

For example, let us say your startup is generating an EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization). of $250,000. Depending on the industry you are in your management, your competition, team, and some additional qualitative aspects, an investor could tell you that he’s valuing your business at say 5X, 10X or 15X your current EBITDA This is a simple and powerful tool for valuation, that investors employ to quickly estimate the value of a startup2.

Summary

Startup valuation methods play a huge role in the startup’s investments. The 5 best startup valuation methods help entrepreneurs to determine the value of the startup and investors to calculate startup valuation to choose the successful ones. However, always remember, that subjective elements cannot be completely eliminated from any of these methods in case of quickly-growing and high-potential startups.

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