Previously, we shared an article about searching for investors. But you would definitely need to discuss your startup valuation with them. We’re all used to seeing stories in the news about how much-established companies are worth and how their value has skyrocketed over the years.
However, when you’re starting, working out your business’s value can be a little bit more of a mystery.
Businesses that have been around a long time base their valuations around how many assets they own, the revenue they generate, and the earnings they receive. If you’re new to the world of business, you may not have all of this information available just yet.
In this article, we’re going to look at how you can put together a company valuation for your startup, and why knowing this information may come in handy.
What is a startup valuation?
A startup valuation is when you use a variety of metrics to determine the financial value of your company.
This will let you see not only how much your business is worth at this moment in time, but how much it will be worth in the future.
Why do you need to know how much your startup is worth?
The key reason you will need a value for your startup is for investment purposes.
If you have decided to go down the route of getting investment, whether, from an angel investor or venture capital (VC) company, they will want to know everything about your business.
A valuation will help them decide whether it is worth investing in your startup. After all, they will want to know if they will make the money that they invest in you back.
Even if you’re not interested in getting outside investment, you may be curious to see how much your startup is worth. It can be a valuable benchmark to have, and you can review it as your business grows over time.
Why is it harder to value a startup business than an established one?
Startups do not have as much financial information to go on as established businesses do.
Some of the reasons why it can be tricky to work out the value of a startup include:
- The product or service that the startup has created may not have yet gone to market
- The startup may not be turning revenue or profits just yet
- The startup will be in a state of instability, making it harder to work out a valuation
Established businesses generally use a formula called EBITDA to determine their current value. This stands for earnings before interest, taxes, depreciation, and amortization (loan payments). It is a commonly used metric for determining a company’s profitability.
If your startup is too small to use EBITDA, don’t worry. There are plenty of other ways that you can work out a valuation of your business. Let’s take a look at some of the most popular methods.
Eight ways that you can determine the value of your business
1. Comparable pricing method
This isn’t the most accurate way to value your startup, but it can be a great starting point. All you need to do is identify a company that is similar to yours and use it to determine your value.
Venture capital investors use a similar method to this to value businesses that they are keen to invest in.
2. Cost to duplicate method
With this model, you look at how much it would cost you to build an identical startup from scratch.
The advantage of this valuation method is that you can use your existing expenses and financial reports to build an accurate figure of how much your business is worth. However, the cost to duplicate method doesn’t take future growth into account, so you may end up with a lower valuation than you may have been expecting.
3. Book value valuation method
Also known as the asset-based valuation method, this is one of the easiest valuation methods to conduct. It is calculated by taking total assets and subtracting total liabilities, figures that you should easily be able to acquire.
Similar to the cost to duplicate method though, it doesn’t account for future growth, so it may result in a low valuation figure.
4. Scorecard valuation method
Commonly used by angel investors, the scorecard method is based on the different methods of success a startup may have. It is sometimes referred to as the Bill Payne method, after the angel investor that developed it.
The method of success that the scorecard method use isn’t financial, meaning that this model of valuation can be used by startups that aren’t turning a profit just yet. Some of the factors that the scorecard valuation method uses include:
- The quality of the startup’s management team. This is one of the most crucial factors according to the scorecard method. A strong leadership team will help a startup grow and provide a good return on investment.
- The size of the market
- The quality of the product or service
- The potential of the sales and marketing channels
- The need for additional investment
The reason why investors like the scorecard method are because as scores are weighted, it allows them to directly compare similar startups on a like-for-like basis.
If an investor has many requests for funding from startup businesses, they can easily see which startup is the most likely to bring a healthy return on investment.
5. Discounted cash flow
This method forecasts how much cash flow that a startup will create over the long term. The business can then calculate an approximate return on investment.
6. The Berkus method
This method of valuation was devised by angel investor Dave Berkus. In this model, five aspects of a startup are assessed, and a value of up to $500,000 is attached to each.
- The concept of the product or service
- The quality of the prototype. More information about building a prototype
- The level of quality management
- The connections and strategic relationships that the startup founder (or founders) has
- The strength of the launch plan
If a startup hits the maximum score, then it is worth $2.5m in total. The higher the value, the stronger the business and a more likely candidate for investment.
7. The Venture Capital method
This method is commonly used by venture capital companies. It is one of the more complex valuation methods that is used, but is also one of the most accurate.
To work out a startup’s value, the terminal value of the business is calculated – this is how much the startup can expect to be sold for. The startup then tracks the expected return on investment and investment amount backwards to come up with a final valuation figure.
8. The risk factor summation method
A blend of the scorecard and Berkus method, the risk factor summation method can help show startups whether they are high or low risk when it comes to investment.
Startups take the following risk areas and assign points – from -2 for extremely high risk to +2 for extremely low risk.
- Management risk
- Stage of the business risk
- Funding and capital risk
- Manufacturing risk
- Technology risk
- Sales and marketing risk
- Competition risk
- Legislation and political risk
- Litigation risk
- International risk
- Reputational risk
- Exit strategy risk
After the assessment has been carried out, the startup can then work out a value depending on the number of points they acquire. The lower the risk, the higher the value.
There are other valuation models available, but from our experience, these are the eight that are most commonly used.
When you have your valuation figure, you can include it in any correspondence with your potential investors or include it in your pitch deck.
Our top tip: whichever method you use to value your business, let your potential investor know. This will allow them to understand how you came up with your final valuation figure.
Of course, they may also want to value your startup using their valuation model of choice.
No under or overvaluing: Why it is so important to get your startup valuation right
When it comes to determining the value of your startup, it’s important not to overvalue or undervalue it.
Undervaluing your business may mean that some investors may choose not to work with you. Alternatively, they may think as your business value is lower, they can ask for more equity to work with you. This may hurt your profits and the control you have over the business in the long term.
Overvaluing your business can be just as bad. Being overly optimistic may lead to you attracting the wrong type of investor, or one that gets frustrated that you are not doing as well as you initially suggested. This may lead them to make excessive demands or even withdraw from your business.
As an example of a startup that was grossly overvalued, take office rental company WeWork. The business was initially valued at $47B, an impressive amount. However, investors pulled their support when they found that the firm had been overvalued when it was trying to attract funding.
Although WeWork survived thanks to a bailout, the business had to make significant layoffs and sell many of its assets as a result of overvaluation.
This may be an extreme example, but it’s best to take the time to work out an accurate valuation of your startup business as possible. You also need to be honest with any potential investors about how much you are worth.
We’ve mentioned it several times before on this blog, but it is far better to wait to find an investor who can work in line with your requirements.
In conclusion – which valuation model is the best?
We’re often asked which valuation model is the right one to use, and the honest answer is… it depends on your business type, your own specific needs, and the information you have at hand.
If you have not launched your startup yet, then it is best to use a model that does not rely on financial data. The scorecard method is a good one for startups as many investors use it themselves, and it is relatively easy to use compared to other methods. However, it is not suitable for all businesses.
It may be a good idea to try two or three different models of valuation, to see if there are any discrepancies. After all, no valuation method is 100% accurate.
Whatever valuation mode you use, it’s essential to take the time and be accurate with your startup value. Undervaluing or overvaluing your business may cause issues in the future.
Remember that no valuation is permanent. If you are unhappy with the valuation that an investor has valued your startup at, your valuation can still grow with time.
We hope that this article has given you some valuable insight into some of the best ways to determine the value of your new startup.
Need some help in valuing your business?
You Are Launched has been working alongside lean startups that want to grow their business since 2014.
Our team of specialists has the expertise and experience needed to help you work out the value of your startup company. Not only this, but we can help put you in touch with investors that will provide you with the funding required to increase your value even more.
Get in touch with us today to see how we can help take your startup to the next level.