Startup Valuation – Essentials, Methodologies, Challenges
Valuation is crucial for every startup because it creates a precedent for winning over investors. Follow our guide to see what methods help to do this
Do you know there are "unicorns," "decacorns," and even "hectocorns"? No, they are not white horsy creatures with beautiful horns and colorful ponytails. They are companies that estimate one billion dollars and more. For instance, "decacorns" are startups valued at $10 billion, whereas "hectocorns" are super-rich companies with over $100 billion value.
According to recent statistics, there are over 1,200 unicorns worldwide as of January 2023. And you certainly know many of them: SpaceX, Stripe, and Canva, to name a few. Do you want to become one? Then you need a good strategy and the best design for startups to grow, avoid stagnation, overcome pitfalls, and, most importantly, receive much-needed funding to get started. For this, you need to understand where you are now and what potential you have. It is here where the valuation of your company is done.
What is the valuation of the startup?
Before moving anywhere, it is crucial to estimate your powers and let experts take a professional look at your company to define your strengths and weaknesses and determine how much cash flow you can bring.
Let's dive deeper into the valuation process to understand its importance, methods, factors, and challenges.
Definition of Startup Valuation
Startup valuation is a process of identifying the true worth of the firm and giving a crucial insight into a company's potential that reveals its ability to use the new capital to grow and hit the next milestone.
It considers numerous factors, including the team's expertise, product's validity and value, inside and outside assets, business model, target market and its current needs and expectations, competitor performance, present and future opportunities, goodwill, and investor expectations.
Valuation analyzes current and past performance and operates with financial data and statistics. Not only does it provide an average pre money valuation, but most importantly, it gives an understanding of the fundamental value of the startup and its idea, brand value on the market, team and product's potential, and the context of fundraising. It undermines an excellent starting point and solid foundation to build a strong business.
Importance of Accurate Valuation of Startup
To understand the importance of a startup's valuation, especially at an early stage, consider what it does:
- Assess the company's worth.
- Determine the weaknesses and strengths of the team.
- Analyze the startup's capital structure.
- Predict future earnings prospects.
- Provide financial opinions on matters of litigation.
- Plan exit strategy.
All these functions are crucial for early stage startups because they clarify the overall situation around the company and eliminate the majority of delusions and biases. On top of that, using financial metrics and analyzing competition and market needs, the valuation process gives insights into future sales and the company's profit.
Another reason why valuation is important is that it secures funding. Investors are interested not only in business models and products but also well-researched and accurate valuation of the brand itself. According to statistics, whatever exciting business idea is, the estimated company always gets more investments. There is more. Companies should also remember that pre money and post money valuation methods give directions for creating an effective financial plan. On top of that, the process does these tasks:
- define the potential of a startup and idea,
- assist businesses in getting tax benefits and exemptions,
- spot trends and opportunities,
- highlight common financial problems and traps,
- provide essential applications for a company at a given point in time,
- set a fair market value for the product and company.
Many successful businesses believe in a company's valuation done at all stages during life because it indicates risks and returns and creates a clear picture of what is happening with the startup company and what matters now. This helps to choose the right strategy for the next period, avoid degradation and stagnation, and secure new investors.
Although there is no exact science for figuring out how much money precisely a company will need to reach the next milestone, still there are patterns and methods to predict that and provide the business owner with a relatively solid ground. Let's consider the popular startup valuation methods.
Methods of Startup Valuations
So, how to get the current company value and average pre money valuation?
The precise valuation of a startup is almost impossible because many factors may distort the picture. However, it still does lots of good, even with relative numbers.
Another good news is the business sector has different startup valuation methods. Some go for valuation by stage model, while others rely on the Berkus method. They may provide great valuation results depending on the niche, competition, product, market, and current development stage. Therefore, it is possible to do an average valuation that can be pretty accurate. Let's consider some of the most reliable methods.
Discounted Cash Flow Analysis
Discounted cash flow method is a financial analysis model that is highly popular among stakeholders and future investors who need to assess the potential value of returns on their investments and make the right strategic decisions. On the other hand, it helps improve startups' financial qualifications and advance in their niche. The central pillar of this solution lies in discounting the estimated projected cash flow. It determines the discount percentage rate by analyzing certain factors, including:
- cost of equity,
- the capital cost of the debt,
- costs on purchasing equipment and hiring new employees, etc.
The formula has three main components:
- The total amount of cash flow a company has in a given year.
- The targeted rate of return on the investment based on the weighted average cost of capital.
- A number of years a company is reporting.
Taking these components and inserting them into the mathematical formula, this method estimates the investment's future value, determines the discount rate and defines future cash flows.
The Berkus method, also known as the development stage valuation approach, is one of the most popular valuation methods among venture capital firms for startups during their pre revenue stage. It caps post revenue and pre revenue valuation and avoids faulty valuations based on projected revenues. In a nutshell, it has two basic steps:
Step 1 - Assign a monetary value to five key factors:
- basic value,
- strategic relationships in the core market,
- production and consequent sales.
Step 2 - Allocate up to $500,000 per factor for a staggering pre money valuation of $2.5 million.
In the end, the sum of those monetary values is the approximate startup value.
Comparable Company Analysis
Comparable company analysis is a popular pre money valuation method used in investment banking niche to compare different companies' values by assessing the entire value of the enterprise. This includes shareholder stakes, the company's debt, and all assets, including current and non-current, tangible and non-tangible, and operating and non-operating. At some point, it reminds scorecard method, but it goes much deeper into examining the competition. The main goal of this method is to estimate how much a startup should be worth based on how it compares to other startup companies. This is done in several steps:
- Defining the right group of competitors. As a rule, these companies are similar according to these factors: industry, size, revenue, growth rates, assets, and even geographic location and number of employees.
- Gathering financial data about each one. This includes share price, market capitalization, earnings before interest, taxes, revenue, and the company's worth.
- Calculating several ratios to compare and contrast. For instance, get the ratio of enterprise value versus revenue.
The main advantage of this method is that it works great for pre revenue startups because it is based on pre revenue valuations of the same companies.
Precedent Transaction Analysis
Precedent transaction analysis is a valuation method that uses past performance results. This cannot be easy with pre revenue startups because some do not have any previous financial data. Nevertheless, it still gives valuable estimations and results that can be used as a baseline valuation of a company that should be improved with other intricate and thorough analyses.
It primarily relies on publicly available information and looks at the type of investors that have purchased similar companies. Using a comparable transactions method, it identifies the most relevant transactions. On top of that, it analyses competitors not just in the same niche but, most importantly, with similar financial characteristics.
In short, it does these steps:
- Seek relevant transactions.
- Analyze available transactions.
- Determine a range of valuation and revenue multiples.
- Apply the valuation multiples to the company in question.
The most significant advantage of this method is that it provides a general assessment of the market's demand for a particular asset. This routine underlies an approximate valuation of the asset.
Rule of Thumb Methods
Discounted cash flow and comparable company analysis are among the most popular and reliable methodologies used by investors and stakeholders. However, they have limitations for startups because of a lack of data, which may lead to poor pre money valuation. In that case, it is highly recommended to use other startup valuation methods because they can provide a more accurate picture of companies, especially for pre revenue startups.
The risk factor summation method and venture capital method are one of those reliable alternatives. The latter is often used for valuing early-stage startups, whereas the risk factor summation method takes into quantitative consideration all risks associated with the business and is applicable to companies at various stages during their lifetime.
There is more. You may consider the following:
- The scorecard valuation method. It compares the startup to other early-stage companies. It considers region, market, and stage and modifies the average valuation.
- The cost to duplicate method. It focuses on costs and expenses and evaluates how much it would cost to create the company from scratch.
- Book-valued method. This trustworthy pre money valuation method evaluates a startup according to total assets minus its liabilities.
- First Chicago method. It gets the most out of discounted cash flow method and multiples-based valuation to create a prediction for the business with different outcomes.
Depending on the current situation in the market, product, development stage, performance, and financial history, you may benefit from them as well.
Factors that Impact Startup Valuation
Whatever comparable company analysis or scorecard valuation method can be good for estimating the value of startups, still making an accurate prediction about ROI is impossible. The main reason is that early-stage companies do not have current data to analyze, especially those without present value. The second good reason is that other factors impact this process. Let's consider them closely because they may drastically influence the valuation.
Stage of development
Every stage of development is unique and estimated differently. As proof, according to stats, startups at an early stage of development are generally valued lower than those further. The stage of development is one of the most influential factors in startup valuations. It even has a say during post money valuation stage. There is more. It also affects the choice of valuation method.
Industry and market trends
Do you know your business will likely fail if your idea isn't in a growing market? Market trends and the current situations in the industry are a cornerstone of your product's success. The bigger the market you're entering, the more attractive the startup investment.
Financial performance and projections
Profits, losses, and other calculations associated with business performance and projections provide a real insight into the financial status of your business. It indicates how well your company is doing and highlights trouble areas. This determines crucial data for accurate startup valuation and its growth potential.
Management team and experience
People are everything to a startup. They are the company's lifeblood which should be diverse. The deal is tech competencies play an essential role in a product's validity; however, nailing the management stage and ensuring your team fills all gaps in expertise to create smooth and productive workflow, serve the market and fight competition is crucial. The studies show companies that fail the management stage drastically distort the actual valuation of the company.
Intellectual property and proprietary technology
These two aspects offer a sustainable competitive advantage. They strengthen a startup's likelihood of obtaining financing from investors. Plus, they give a better vision of the company's value.
Challenges in Startup Valuation
As mentioned, startup valuation is an art, not a precise science. There is no guarantee that it estimates an exact cash flow or revenue growth. However, even yielding a relative number, it still does good for the company. Therefore, it is vital to minimize factors that may influence it and overcome challenges during this process. There are three main obstacles:
- Lack of historical financial data.
- The high degree of uncertainty and risk.
- Difficulty in predicting future performance.
Lack of historical data
This problem occurs mainly with early stage startups because of their short track record. Even if they have one or two years of data available on financing, as a rule, many pre revenue businesses have negative cash flows for the first few years. Therefore, the startup's valuation method based on financial data fails to give precise predictions. This also affects approaches that rely on past market performance.
The high degree of uncertainty and risk
The high degree of uncertainty and risk appear under these conditions:
- abundance or vice versa, lack of information,
- conflicting nature of pieces of information,
- subjective interpretation of information,
- measurement errors.
Believe it or not, even the most straightforward decisions carry some level of uncertainty and risk. Therefore, business owners must accept that and face the possible incorrect interpretations generated by some startup valuation methods to mitigate its consequences.
Difficulty in predicting future performance
According to statistics, most startups take way longer than you think to develop. There are many reasons for that: tough competition, overconfidence, market fluctuations, economic crisis, the talent pool, etc. Usually, it takes from 5 to 10 years to reach the first substantial milestone for companies. However, this timespan is too much for making an accurate prediction about future performance. As a result, startup valuation strategies struggle to be accurate.
Last but not least
Along with these three significant challenges, other obstacles may falsify startups' valuation process. For instance,
- Little or no revenue or negative earnings.
- The toughness of survival.
- Hidden costs in forecasting.
- Positive free cash flow.
- No similar companies to draw a direct comparison.
- Not fully captured additional risks such as technical problems, poor-quality management team, etc.
- No effective tax rates.
- Lack of liquidity in investments.
- Dependency on key personnel.
- Individual biases that constantly lead the company astray.
How to Overcome These Obstacles and Improve Startup Valuation Process?
Some of the obstacles featured above are inevitable, like the lack of historical financial data for early-stage businesses. Plus, whatever valuation method you choose, it is almost impossible to calculate precisely how much cash flow will be in several years. Nevertheless, there are some good practices and tips that help companies to improve the outcome of this process. They are the following:
- Choose the suitable valuation model for your current development stage.
- Adopt multiple methods during post money valuation period and pre money valuation period.
- Enrich the valuation with qualitative data.
- Foster greater transparency within the venture capital and startup company ecosystem.
- Reduce uncertainty and risks by changing actions and strategies.
- Factor probability into the valuation process that faces risks and uncertainty.
- Revisit and reconsider the initial valuation done during the estimated company value stage at other periods.
- Tweak target segments and business models.
- Find a deal structure that accommodates both entrepreneurs' and potential investors' preferences and expectations.
- Identify signals of business change.
- Expand horizon.
- Determine a range of possible futures.
- Secure a strong management team.
- Do not let hidden biases cloud foresight.
- Do not adopt business legislation contrary to laws.
- Take seriously post money valuation methods.
Startup valuation is arguably the most fascinating but also the most daunting process. Although it provides relative numbers and only predictions about future performance and revenue, it is still crucial for businesses at all stages during their lifetime, not only the first years. This process brings multiple benefits for pre revenue companies:
- It sets the company on the right trajectory to the next round of funding and eventual success.
- It undermines risks that need to be mitigated.
- It sets targets more likely to be achieved during the next period.
- It helps founders to make the right decisions for the company at the given time.
- It helps to make a broader plan and create a company's future vision.
- And most importantly, it gets funding from investors.
As for investors, this process is a cornerstone of their success. First and foremost, it decides how much investment they can receive and how much they might have to give away. Second, it underestimates the venture's worth so they can decide whether to participate in its growth or not.
Startup's valuation is a complex process that considers numerous factors. It can be done with the help of different valuation methods. Plus, numerous challenges need to be minimized and mitigated. However, it needs to be done because it sets the company on the trajectory of success and significantly boosts the venture. Therefore, secure experienced professionals to navigate the complexities of startup valuation, follow the best practices, make a commitment to the cause, and be honest with yourself to do your best.
Updated: May 31, 2023