Startup Valuation: How to Calculate the Value of your Business
Common methods of startup valuation. What information do you need to evaluate the company and where to find it?
Valuation of a startup is a process of determining its value based on the analysis of a number of indicators. To fully evaluate a startup, you need to get information about its revenue, risks, gains, losses, and other data.
The goal is to provide entrepreneurs and investors with comprehensive tools for making decisions on whether to buy, sell, or fund startups.
What is a startup valuation?
Valuation is biased by its nature. Apart from real factors, people rely on subjective conjectures and rough assumptions — such as the approximate forecast of sales growth for the next three years. Thus, the valuation of a startup should be perceived at best as an educated guess, with a certain error margin.
Who needs startup valuation and why?
There are two ways of evaluating a company: through its market value or internal value.
The market value, obviously, reflects the company’s value from the market’s point of view. The overall economic situation might make it change because of external factors. Therefore, businesses can be overvalued or undervalued. The market valuation is more relevant for public companies. Startups, as a rule, remain private and are not publicly traded.
The internal value reflects the company’s real price in isolation from the current market. The overall economic situation does not influence it that much. Since startups usually lack market valuation, investors focus on their internal value.
Startup valuation enables analysts to calculate its internal value with less regard to the market. However, analysts are not the primary beneficiaries in this case.
Founders are the first ones to resort to startup valuation. They use this data for the following processes.
- Selling the startup or shares in it, calculating the value of shares
- Establishing more substantive communication with investors when searching for funding
- Increasing people’s trust in the startup through a transparent cost assessment
- Calculating the value of the warrants that the employees have already purchased or are planning to purchase
- Calculating the taxes for employees who own shares or warrants
- Calculating the preliminary share price (409A valuation) when issuing warrants
- Estimating the company’s success and the dynamics of its development, comparing it with other market players
- Building the development strategy
- And much more.
Equally, venture companies and M&A departments in corporations resort to startup valuation in order to:
- track fluctuations of their portfolio value,
- analyze the prospects of a particular acquisition,
- use the evaluation data to negotiate the purchase of a share in a startup,
- sell their shares in a startup (exit).
Investment bank specialists use startup valuation to provide efficient support to clients regarding the issues of purchase and sale as well as investment. The evaluation data is important for compiling industry reports and attracting new customers.
Finally, the least active category is retail investors — that is, individual non-professional market players. They require access to the valuation data of public companies to make investment decisions. These include startups that have gone public. Such information enables investors to diversify their portfolios and maintain a balance when allocating investments.
Which data do you need to evaluate a startup?
Financial reports. Detailed information about gains and losses allows you to compile forecasts for funds transfers, profit, and growth rate. Startups with good growth prospects have a higher evaluation.
Managerial experience. The professionalism and experience of the startup team affect the estimated value of the business, especially when the management has a track record of other successful projects. If the CEO is the only driving force behind the startup, investors will regard this as a risk factor.
Market conditions. External factors should be taken into account: the state of the economy and the sector, the level of interest rates, average wages, competition. For instance, a startup that has appeared in an overly popular niche will receive a lower value appraisal.
Intangible assets. Reputation, trademarks, customer base — all these factors are not subject to objective valuation. Yet they can significantly affect the final verdict.
Tangible assets. This is equipment, real estate, vehicles, and other real-life objects. Their cost should be calculated and added to the overall value appraisal of the startup. The higher the quality of tangible assets, the higher the surcharge.
The size of the company. The larger it is, the higher its revenue (as a rule). If the staff is numerous enough, the potential loss of key employees and managers will not be critical for the business. Also, large companies tend to have more tangible and intangible assets. Therefore, large companies usually have a higher value if compared to their smaller competitors.
Competitive benefit. The instability of the competitive benefit or the inability to maintain it will immediately affect the valuation of the startup.
Where to find data for analysis?
The valuation of the startup depends on the initial data. When analyzing your own startup, you, obviously, have all the necessary information. But what if you need to analyze someone else’s project? The task is complicated by the fact that not too many startups have gone public. The main share of venture projects is private companies that are not required to disclose information about their finances.
To estimate the value of a company, investors, analysts, and entrepreneurs rely on a wide range of sources:
- public documentation (IPO, S1, SEC reporting),
- information from the media about investments, sales, and so on,
- estimates by other experts,
- unofficial forecasts of stock returns.
Methods for evaluating startups
The market value of a startup reflects how market participants and investors evaluate this company. For instance, public companies can be evaluated using their share prices. If a startup has issued 100,000 public shares for 50 dollars each, its market capitalization will be 5 million dollars.
However, the value of a public company might go beyond its market capitalization. Private companies require a completely different approach.
We have conditionally divided the approaches for evaluating startups into two categories: startups that generate income and those that have not yet reached the break-even point.
Methods for profitable startups
The valuation of profitable private companies that have started generating sales is usually carried out using discounted cash flow (DCF), multipliers, or net worth. You can use these methods independently or combine several of them to cross-check the results.
1. Discounted cash flow
The DCF method is based on the calculation of future cash flows and their discounting. It is used to evaluate young startups that lack stable financial data.
Its essence is to reduce all the funds realized in different periods of the startup’s life to a one-time point, usually the initial or final one. This allows you to clearly compare the volumes of funds and then perform the necessary operations with them — such as to sum.
Despite the complexity of the DCF method, it is widely known and can be applied in any field. When evaluating a startup, you need to operate with three factors:
- Risk-free interest rate. Low-risk investments (for example, federal loan bonds) provide investors with a risk-free interest rate. Therefore, private companies with high and medium risks must provide more attractive returns than low-risk alternatives to motivate people to invest in them.
- Illiquidity premium. Shares on major stock exchanges can be quickly purchased and sold. You cannot do the same with the property of private companies. This increases the discount rate since investors need time to find buyers.
- Risk premium. Only 10% of startups live up to a decade. Yet even among these survivors, many companies fail to meet the expectations of their investors. A risk premium is an attempt to fix and prevent risk factors in the discount rate.
2. Valuation based on multipliers
Multiplier analysis is performed on the basis of the coefficient obtained when dividing one financial indicator by another. You should take indicators of different but comparable companies. You can also use common multipliers for the whole sector. For example, in the summer of 2020, the average multiplier for international SaaS projects was 11.4 and the median was 8.2.
Example: the A company builds mobile games with an income of 10 million dollars. Its competitor, the B company, was purchased for an amount that exceeded its income by 5 times. Its income was comparable to what the A company got. So, company A estimates its value at 50 million dollars.
This method might cause difficulties for several reasons:
- It might be difficult to find data, especially if there are no similar companies in the industry.
- The revenue and profit indicators are static. We have to use the B company’s data from 2018 to evaluate the A startup in 2020, although a lot has changed for competitors in 2 years.
- We don’t take into account the individuality of each company. Financial indicators alone cannot determine the effectiveness of the business.
- It does not make sense to compare private companies with public ones, since they have different conditions and risk levels.
3. The method based on the value of net assets
The NAV calculation suits companies with large volumes of tangible and intangible assets. However, this approach to evaluating startups does not take into account the bonuses that the market accrues to a startup for its prospects, competent management, low risks, and so on. Therefore, the NAV method usually delivers the lowest score.
Methods for startups that do not generate income
It is more difficult to evaluate startups that do not generate income yet. They lack profit indicators, so you have to use other parameters — such as traction, the merits of the founders, and market trends.
4. The Berkus method
The Berkus method evaluates the key parameters of a startup: business idea, prototype, team, strategy (or board of directors), and sales plan. Each factor can be estimated at up to $500K, which allows young startups to reach a value of up to $2.5 million. The essence of the Berkus method is to evaluate the elements of risk reduction in monetary terms.
|Reliable board of directors||$100K–500K|
5. The method of summing up risk factors
Using this method, you should evaluate 12 risk factors by assigning them scores from -2 to +2. Negative points reduce the final score and positive ones increase it. The method of summing up risk factors can be characterized as a continuation of the Berkus method. Here, the maximum factor estimate is also $500K.
|Risk factor||Points||Value ($)|
|Development stage||-1||– $250K|
|Conflict with the law||+1||+ $250K|
|Production and logistics||0||0|
|Sales and marketing||+1||+ $250K|
The scoring method compares a startup with funded competitors that operate in the same sector or region. You should take the following aspects into account:
- product or technology,
- competitive environment,
- sales and marketing,
- additional funding needs,
- and so on.
First, you calculate the average value of similar startups. You need to take into account the date of publication of the estimated data — it could be affected by changes in the market, the recession, and other circumstances.
The second step is to determine which factors affect the effectiveness of similar companies and distribute the degree of their influence by percentage.
At the last stage, you need to give the evaluated company scores for the selected factors. 0% means that the startup’s performance on this parameter is very poor and 100% means that it is quite efficient. For example, if you have assigned 150% to the management, it means that you consider them exceptionally competent.
When multiplying points with percentages, you get the multipliers:
|Team competence||30% max||125%||0,3750|
|Market size||25% max||150%||0,3750|
|Product and/or technology||15% max||100%||0,1500|
|Marketing / sales / partners||10% max||80%||0,0800|
|Additional financing||5% max||100%||0,0500|
|Other factors||5% max||100%||0,0500|
Earlier, we calculated the average value of similar startups. Now, let’s multiply it by the sum of the multiplicators — and we’ll get a figure that corresponds to the value of the startup. For example, if a company was assigned a multiplicator of 1.075 and the average value of similar startups is $1M, the company will be evaluated at $1.075M.
7. The venture capital method
The venture capital method takes the value after income is received and uses it to calculate the value before income was received. To find the future value of an asset, you need to multiply the projected income by the projected margin and by the price-to-earnings ratio (P/E multiplier).
For instance, in the next 5 years, a pharmaceutical startup expects to receive revenue of 20M dollars with a profit of 20%. The price-to-earnings ratio is 10. The value of this business in the year of sale is calculated using the following formula.
20M × 20% × 10 = 40M dollars
Let’s calculate the pre-income value. To do this, you need to determine the profitability (ROI) and the amount of investment. Suppose an investor wants to get a 20-fold ROI for an investment of 500K dollars. The value is determined by the following formula.
40M / 20 – 500K = 1.5M dollars
Which approach should you choose to evaluate a startup?
In addition to the seven methods that were mentioned above, there are a few others. All of them might deliver different valuation results for the same startup. Therefore, it makes sense for the founders to carefully select the methodology according to their goals. For example, if you are going to sell your company, you will benefit from a higher valuation. And vice versa: when buying a business, you would definitely prefer a reduced value.
Mind that established traditions in certain industries might influence your choice of methodology when evaluating startups. Similar enterprises are usually evaluated using the same method. You should also take into account the unique characteristics of the startup’s products and technologies. An innovative business is more likely to prefer a method that focuses on the future growth potential rather than current assets.
Ultimately, you can always use multiple methods to evaluate your company and stop at their arithmetic mean. Otherwise, when conducting negotiations, you can rely on a whole range of methods.
How to determine that a startup is undervalued or overvalued?
A company is considered undervalued when its market value, expressed in market capitalization or the valuation of venture investors, differs downwards from the estimated internal value. With an overvalued company, it differs upwards.
The problems of overvaluation and undervaluation are relevant not only for public companies but also for startups. For example, if someone invests money in an undervalued project, the share that they receive will be too big. This might have the following consequences.
- The personal motivation of the founders will reduce.
- It will be difficult for the startup to raise funds in the future since the team’s motivation is an important factor for venture investors.
Overestimating a startup’s valuation might also have meaningful consequences.
- It will be more difficult for the team to reach the proper financial indicators in the next round.
- They will need to lower the startup’s valuation, which might lead to a conflict with their first investors.
- The company might find itself in a dead-end without the opportunity to attract new investments.
To identify the true value of a startup, you should conduct a fundamental analysis. It involves the assessment of not only external events but also a number of financial parameters, such as the following.
|Price-to-earnings ratio (P/E)||If it is lower than the market average, then the company might be undervalued. If it is higher, the company might be overvalued.|
|Profit-to-sales ratio (P/S)||If it is lower than the market average, then the company might be undervalued. If it is higher, the company might be overvalued.|
|Bond yield||If it exceeds the yield of US treasury bonds, the shares may be undervalued.|
|Return on equity ratio (ROE)||If it is higher than the market average, then the company might be undervalued. If it is higher, the company might be overvalued.|
|Price-to-book ratio (P/B)||If it is below 1, the company might be undervalued.|
When carrying out the analysis, you should pay attention to the risk of falling into the value trap. Under favorable economic conditions, some companies (for instance, car manufacturers) get huge profits and a low price-to-earnings ratio.
Inexperienced investors might consider this a sign of undervaluation and begin to invest massively in such industries. By the end of the economic growth cycle, there will be a recession and a market correction, due to which the prices of the company shares will drop and investors will lose money.
Which option should you choose? The need to select an optimal methodology might impact the final estimates. Different experts may come to different conclusions about the value of the same business.
Besides, in real life, everything depends on the plans that the assessment pursues and the market environment. Most often, people analyze evaluations of existing similar projects and use them as the basis for their own calculations. Then, they precise their estimates using the methodologies that were described in this article.
The valuation of startups takes into account many factors, both objective and subjective. To get the most accurate results, you need to get a wide layer of data about the company. If you lack this data, the valuation will be rather complicated. It is important to remember that the valuation of the company is a dynamic process, as it changes depending on a number of circumstances.