Startup valuation is the process of evaluating the precise value of a startup business for a given period of time to predict its future growth and performance. It provides insight into the ability of the startup to consume its new capital to grow and meet the expectations of the customers and investors and how the next milestone would be achieved. Valuing a startup is crucial as it lacks financial history or future certainty. It operates in both dynamic as well as competitive methods. Therefore, different methods and approaches are used to obtain the valuation. To talk more on the subject, today we are here with this comprehensive guide on startup valuation.
Importance of Startup Valuation
A startup valuation is primarily done when the company requires additional funding. Some of the other reasons for startup valuation are as follows.
- Equity Plans: A proper equity plan, such as stock options or ESOP, should be revised annually unless other events have occurred. It is because the strike price, which determines how much employees and key collaborators can pay to exercise their stock options, depends on the latest company valuation.
- Funding Rounds: Business valuation becomes essential when a new or existing investor is willing to purchase on primary or secondary. In the primary market, new shares are issued, and the existing shareholders are diluted proportionally. While in the secondary market, investors trade the existing shares.
- M&A: In the case of mergers and acquisitions, startup valuation becomes essential and is primarily the center of negotiations. Valuation may not be required when the acquisition is in cash, but it is uncommon to have a financing round to support any transaction.
- Strategic Planning: For large and upscale companies, they have a team to evaluate the performance and prospects of each business unit. And to determine whether to invest, it's very important to have an independent P&L, subsidiary valuation, or cash flow analysis.
Methods to Calculate Startup Valuation
There are numerous methods and approaches to evaluate the valuation of a startup. Some of these are.
- Berkus Method: Berkus Method is also known as a development stage valuation approach which pre-revenue startups often use to contrast their attributes with competitors and secure better opportunities. The basis of the valuation of such a method is upon key success factors like technology, basic value, strategic relationships in the core market, production, and sales. This method enables investors to understand whether the startup has generated revenue.
- Comparable Transactions Method: The Comparable Transactions Method identifies the total number of startups in the same industry acquired in recent years and then uses the information as a benchmark for valuing the startup. Determining the suitable value range for the startup is simpler by examining comparable transactions. This method is suitable for comparing those two startups which create similar products or services.
- Cost-to-Duplicate Approach: All costs and expenditures related to the startup are considered, including the acquired physical assets. It helps determine the fair market value of the startup. Investors use this method to invest at a higher valuation or more than the market value of startups. This method does not consider the startup's future potential sales and growth.
- Discounted Cash Flow Method: This method depends upon the market analysis that helps in anticipating the future growth of the startups and how it may affect their overall profit. It determines what a startup could generate by evaluating the investment return rate so that its value can be projected.
- Future Valuation Multiple Method: This method is used by investors to estimate what the investors should expect in the future using the return on investments. It includes assessing growth projections, cost, and expenses projections. Then the multiple is applied to the relevant metric to estimate the startup's value.
- Risk Factor Method: This method enables the startup to assess the likelihood of its future success. It combines 12 factors that influence the return on investment, such as manufacturing, management, technology, political and competition risks. It helps evaluate the initial estimated value through methods like Berkus or the scorecard valuation method. Then, the final startup value is determined by subtracting or adding risk values to the initial estimated value.
- Discounted Cash Flow Method: The company’s free and stable future cash flow is projected using historical data and plausible assumptions. Subsequently, the discount rate, which is the anticipated rate of return on investment, is determined. A high discount rate is applied since these new startups have a high investment risk. The future free cash flow is then discounted to its present value.
Key Factors Affecting Startup Valuation
Some factors influence the valuation of a startup. These key factors are.
- Traction: It is the most important factor in validating a startup’s valuation. It demonstrates that the startup has customers willing to pay for its product or service.
- Reputation: When the startup has a good track record of creating innovative ideas or has a great product or service that built a good reputation, there is a high chance that the startup will have a high valuation, even if it lacks traction.
- Revenue: This is more common for business-to-business startups than consumer startups. Having revenue streams such as charging users helps startups to obtain a more favorable valuation.
- Distribution Channel: With an effective distribution channel, startups can achieve higher valuations, as the location of their product sales is very important.
- Prototype: A prototype that a startup showcases its product or services also contributes to a higher valuation, as it demonstrates the feasibility and functionality of the solution.
- Supply and Demand: When business owners seek more money than the investors are willing to invest, this could affect the valuation.
Challenges of Startup Valuation
Valuing startups may face several challenges that must be overcome for a successful valuation. Such challenges are.
- Lack of Comparables: Startups often use advanced technology and unique business strategies that lack established comparables or standards. It is hard to find comparable businesses for valuation purposes because of their uniqueness. Also, the comparables may have raised funds only through private offerings by issuing securities not traded on public markets.
- Insufficient Financial History: Since these startups are new, they lack any financial history, which makes it challenging to assess startups' performance, potential profitability, and revenue generation.
- Funding Round Dependency: Startups often use various funding rounds to expand their businesses. Because of this, the valuation may change based on the market conditions, investor opinion, and the company's development, resulting in complications in the process.
- Uncertainty in Future Prospect: Startups face uncertainty in their valuation because they operate in dynamic markets, making it hard to forecast their future growth. One of the major challenges in valuing startups is assessing the magnitude of the potential market and the proportion of it that the company can acquire.
Key Terms for Startup Valuation
- Funding Rounds: The number of rounds a startup tries to raise money from the market for its growth or expansion is called funding rounds. Sometimes, a startup may also receive unsolicited offers or participate in auctions to secure funding for its operations.
- Berkus Method: This type of valuation method created by venture capitalist Dave Berkus evaluates a pre-revenue startup based on five key success factors and assigns a dollar value to each of them.
- Pre-Money Valuation: It is the value that a startup has before receiving any external funding from the investors.
- Post-Money Valuation: It is the value that the startup becomes after receiving external funding from the investors. The method to calculate it is by adding the pre-money valuation and the total funds raised.
- Distribution Channel: A network of businesses or intermediaries helps a final buyer acquire a good or service.
Final Thoughts on Startup Valuation
Determining the valuation of a company is extremely important and difficult, especially during its initial stage, when there is no certainty of future success or failure. It is a rather difficult task requiring science and art and comprehensive industry knowledge. The approaches we have discussed in this blog play an important role in evaluating the precise valuation of a startup and predicting the company's future growth.
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