In layman terms, startups are the new business ventures started by an entrepreneur. A startup is like raising a child. You need to put money into it from time to time for it’s growth. Whenever you pitch your idea to an investor, it is likely that the first question will be, ”how much is it worth?”. Usually, the investors try to undervalue the startup whereas the management team tries to overvalue it. There are numerous methods of valuing early stage startups. These are the 5 most common of them.
The Berkus Approach looks at valuing a start-up based on a detailed assessment of five key success factors:
- Basic value
- Strategic relationships in its core market
- Production and consequent sales
A thorough assessment is carried out by evaluating how much value the five key success factors (in quantitative measure) add up to the total value of the enterprise. Based on these numbers, the startup is valued. This approach may also be referred to as the “Stage Development Method or the Development Stage Valuation Approach.”
For example, $500,000 maximum value to each element yields either a maximum pre-money enterprise valuation of $2 million or $2.5 million if all elements are “perfect” for a target in the eyes of the investor. Yet, the current HALO Report from the Angel Capital Association containing average pre-money valuations for angel investors demonstrates that the US average, at least for the moment, is higher than this amount. Valuations are higher in Silicon Valley, Silicon Beach, New York and the North Carolina corridor than in Oklahoma City, Kansas City or Miami.
Once a company generates revenue, the method is no longer applicable because then, the actual revenues will be used to project value over time.
The Cost-to-Duplicate Approach considers all costs and expenses associated with the startup. This is done to predict the startup’s fair market value based on all the expenses.
For example, for a SaaS (Software as a Service) startup, might include factors like the cost or time taken to program and design the product. It might also include research and development costs, cost of acquiring physical assets, etc.. A tech startup could consider the costs of developing their prototype, patent protection, and research and development.
However, the method doesn’t take into account the potential for growth, future sales, and return on investment, or intangible assets such as brand loyalty.
This usually means that the startup is undervalued, i.e. valued below its actual worth.
Market Multiple Approach
The market multiple approach values the company in comparison with recent acquisitions of similar companies in the market.
Let’s say mobile application software firms are selling for 5x sales. Knowing what real investors are willing to pay for mobile software, we could use a 5x multiple as the basis for valuing our mobile apps venture while adjusting the multiple to factor for different characteristics. If a mobile software company was at an earlier stage of development as compared to other comparable businesses, it would probably fetch a lower multiple than 5. It is because investors are taking on more risk.
This factor of 5 is arbitrary and depends on the industry. For more traditional industries the factor is about 3X (3 times revenue for the previous year). For software companies the factor is higher and for emerging sectors, the factor can be even higher.
However, there’s a catch here. Comparable market transactions can be very hard to find. It’s not always easy to find companies that are close comparisons, especially in the start-up market. Moreover, deal terms are often kept under wraps by early-stage, unlisted companies. Some ways to capture this information is via startup market intelligence companies like Tracxn, CB Insights, Pitchbook, etc.
Risk Factor Summation Approach
Under the risk factor summation method, an estimated initial value is calculated for the startup using any one of the other methods. To this initial value, the effect (whether positive or negative) of different types of business risks are taken into account. Then, an estimate is deducted or added to the initial value based on the effect of the risk. The type of risks include:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each risk (above) is assessed, as follows:
- +2 very positive
- +1 positive
- 0 neutral
- -1 negative
- -2 very negative
The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2).
As an example, assume the average pre-money valuation of pre-revenue companies in your area is $2.0 million. If our judgment of the twelve factors above has five neutral assessments (five zeros), five +1’s, one -1 and one -2 (a net of two +1’s), then add $500,000 to the average valuation of $2.0 million, arriving at a $2.5 million pre-money valuation.
Discounted Cash Flow Approach
The Discounted Cash Flow (DCF) Method focuses on projecting the startup’s future cash flow movements. A rate of return on investment, called the “discount rate,” is then estimated based on which it is determined how much the projected cash flow is worth.
A high discount rate is preferred because startups are just starting out and there is a high risk associated with investing in them.
The following steps should be taken:
- Step 1: Create financial projections for your firm
- Step 2: Determine the future “free cash flows”
- Step 3: Determine the discount factor
- Step 4: Aggregating all your calculations’ results
- Step 5: create different scenarios and analyses
The common problem with the DCF analysis is of quality. It depends on the analyst’s ability to forecast future market conditions and make good assumptions about long-term growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected rate of return used for discounting cash flows. In order to sum it up, the DCF analysis needs to be used with much care.
This research article has been produced by Investocracy, a company focused on connecting startups from emerging markets with Japanese investors.
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