Methods Used to Value Early-Stage Startups
Digital Strategist and Consultant, Growth Hacking Specialist worked for both startups & big brands.
With a rise in entrepreneurial spirit, numerous startups have sprang up. These startups are just like babies in the marketplace, looking for opportunities and finances to expand. If however someone were to ask startups about their worth in the business world
, they will usually get frustrated. Valuing an early-stage startup is very different from valuing an established one.
Whenever you start nurturing your startup baby, it starts increasing its value in the market. When you add a patent in its platter, the value starts rising. What if you add a kick-ass management team? Of course, the baby startup will begin increasing its worth. Easy, right?
The real question however is, how will you determine the value of your startup at an early-stage? In order to raise the startup, valuation is a must. Therefore, understanding how the startup valuation process works is significant to any serious and committed entrepreneur.
Before working on the methodologies of finding the startup's perfect value before generating revenue, it would be advisable to understand the meaning of startup valuation.
What is Startup Valuation?
Startup valuation is a kind of process that helps one figure out the worth of a company. When a company starts its operations, they don't have so much money in their coffers to operate it; let alone pay the salaries of their employees. Thus in the seed funding round, startups offer equity to the investor in exchange for their funds. This is why startup valuation
is a necessary process.
It helps to determine what equity of startups that organisations can offer to the investors or employees. Finding the value of the startups also helps the investors know how much shares they will receive in place of the funds invested during the seed stage. In general, startup valuation can prove to be the real deal maker or breaker. This could help to build a successful business in the marketplace or ruin all the business operations. This is why, business valuation doesn't work on any guesswork or thrive based on the valuation of other similar startups.
In addition, before starting work with the calculation of the company's actual value, the founders would need to have proper knowledge of the entire process. Let's suppose, a company just guesses an absurdly high figure to seed investors, even though they haven't generated any revenue until that time.
Here, it has developed a deal maker or breaker situation. If the startup isn't able to make that much revenue, then it might have to raise funds at a lower valuation in the next round. This might prove negative in terms of long term projects. That's why, it is advisable not to use guesswork while calculating the value of startups.
What are the various valuation factors for startups at the seed stage?
Got the understanding of startup valuation? All business owners of startups need to find out the worth of their venture in the marketplace. This could help them grow the business more effectively without any hurdles. Also, startups should find out the exact valuation of their startups because a wrong valuation can actually break the startup operation.
So, now the question is , “how will you calculate the exact startup value?”. There must be some methods to evaluate that. Well, some methodologies can be used to figure out the exact value of the startup. But before, let's gather some information about the factors which influence the valuation of a company:
In order to influence the investor to invest in the startup, it is important to develop the prototype for the company. It shows that the company has already reached a certain level of execution and achievement for the go-to-market phase. In this way, startups can build a positive impression on investors. Make sure that the prototype is ready to go before the startups start planning to pitch to an investor.
There is no denying the fact that generating revenue is pretty essential for any company. It helps to keep on carrying out the valuation process more easily. If a product has hit the market and starts generating good revenue, it will automatically increase the value of the startup in the marketplace. It could also influence the investors in favor of the startup, and prove to be a real deal sealer.
Distribution channels play a crucial role in finding out the startup value. However, some business owners have underrated this role in the startup strategy; this is not a good idea. When the target company has the distribution channels in one place, the startup valuation will certainly be higher than one without them.
Traction is one of the significant factors that influence the valuation process of startups at the early-stage. When the startups are attaining the targeted customer's baseline, then the traction shows that a startup is taking off. To be more precise, traction portrays the growth and development standard of the company. This is why it is considered the most important aspect that convinces investors to invest money in a company.
One of the most important things that an investor always looks at before investing is the founder's image and his capability. If your startup image is igniting a positive spark in the business world, automatically, there are chances that your startup's value is good compared to other competitors.
If you are launching a startup
in a booming industry, such as the mobile gaming or fintech) industry, investors are more likely to pay a premium when buying equity. It means that if the startups fall in the industry, which does not show any growth in the business world, it will not help the businesses increase the worth of a business enterprise.
Pre-money valuation Methodologies
By now, you are familiar with the various factors that influence the startup valuation process. To find out the value of the startup, you need to follow some formulas. Being aware of every method to figure out the startup's value will help you leverage and negotiate your own valuation with investors. There is no one-size fit all method that can help to find out the value of your startup, so it is better to get insights on valuation methodologies from other entrepreneurs and angel investors. Below are three pre-money valuation methodologies that are often used-
Scorecard Valuation Method
The first and foremost valuation method that can be used to find out the startups' value is the scorecard valuation method. The angel investors generally use this method to compare the startups to other funded startups, modifying the average valuation depending upon factors like region, market, and stage, then deciding the value of the startup against this benchmark. Below are some steps that you need to follow in order to find out the startup value.
The first and foremost step is to determine the average pre-money value of the companies in the same region and sector of the target startup.
The second step is to get the pre-money valuation of the early-stage startup using the Scorecard Method. The scorecard is as follows,
- A requirement of Additional Investment – 0-5 %
- Management Team's Strength of the Management Team – 0-30 %
- Market Opportunity's Size – 0-25 %
- Technology-driven end Product – 0-15 %
- Competition in the Marketplace – 0-10 %
- Marketing + Distribution Channels + Strategic Partnerships – 0-10 %
- Other – 0-5 %
And the last step is to assign a factor to the above-mentioned factors depending on the target startups. Then get it multiplied by the blend of the elements by the average pre-money valuation of pre-revenue companies.
Venture Capital (VC) Method
The next method that can be used to prepare startup valuation is the venture capital method. Basically, this method has gained popularity because of Harvard Business School’s Professor Bill Sahlman. This method helped the professor to find out the pre-money valuation. In order to incorporate this method to find out the net value of the business, it is essential to determine the post-money valuation using industry metrics.
The formula to find out the pre-money valuation involves the post-money valuation of the startup, which gets subtracted with the investment.
Pre-money valuation = Post-money valuation — Investment
To find out the post-money valuation, you need to first determine the terminal value, which gets divided by the Expected Return on Investment (ROI).
Post-money valuation = Terminal value ÷ Expected Return on Investment (ROI)
What do we mean by terminal value? It is an anticipated value of the assets on a certain date. This projection period is generally fixed between four to seven years. Due to this timeframe, the terminal value is usually translated into the present value.
To determine the terminal value, companies need to research the average sales of the established company within the same industry and multiply it by a multiple of two. For example, the startup is rising at a price of $600k, and it estimates that it will generate $30M when it is sold within five years.
- Terminal Value = $30M x 2 = $60M
For the angel investors, the statistical fail rate is over 50%, so investors would target 10x-30xROI on each individual investment. In this example, it will be anticipated that ROI would be set at 20x for the pre-revenue startup. Knowing you're raising $600K, we'll then work on to calculate the pre-money valuation.
- Post-money valuation = $60M ÷ 20x = $3M
- Pre-money valuation = $3M — $600K = $2.4M
Risk Factor Summation Method
Last but not least, the pre-money valuation that can be used to find the value of the startups is a risk factor summary method. This methodology is used to get a more detailed estimation based on the risks involved with an investment. The following are the risks that will be considered in this method-
- Technology risk
- Sales and marketing risk
- International risk
- Reputation risk
- Potential lucrative exit
- Stage of the business
- Competition risk
- Legislation/political risk
- Litigation risk
- Funding/capital risk
- Manufacturing risk
Each of these risks gets the score so that businesses can find out the value of the startup-
- 0 – neutral ($0)
- +1 – positive (+$250,000)
- +2 – very positive for scaling the startup (+$500,000)
- -2 – very negative (-$500,000)
- -1 – negative for scaling the startup (-$250,000)
By incorporating the risk factor summation method, we assume that the increase of pre-revenue startup valuation is $250,000 for every +1, and +2 for every $500k. On the other hand, when the pre-revenue valuation falls by $250,000, then the risk factor will be considered as -1, and by $500,000 for every -2.
This technique would be well-suited while examining the risks involved in starting the business. It helps to manage the business operations to make a successful exit. If the businesses want to have a holistic overview of the startup's valuation, then this method is paired with the Scorecard Method.
You would have a better idea about the importance of startup valuation, factors influencing the calculation, and how to find the startup valuation at the early stage. As a matter of fact, figuring out the worth of the startup plays an important role, whether it is about attracting investors or operating the startup successfully.
But startups at early-stages are also required to choose the pre-valuation method as per their startup niche. However, using multiple pre-revenue valuations methodologies does not prevent other investors from choosing other startups within the same industry. Decide the best method as per the startup's need and niche, and start working on it.
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