Updated: Apr 6, 2018
Planning a pitch to investors? Then you will need to understand exactly how investors value startups before you can secure favorable terms. This article will take you through the commonly used methods for startup valuation.
Without the benefit of a steady revenue stream, startup valuation can be very subjective. Many of these valuation methods rely on estimates and assumptions. The value of your startup is ultimately determined by the amount that someone is willing to pay for it. For that reason, several methods are usually used together and adjusted to reach a particular conclusion.
With so many methods to use, when should you use the different methods? Based on the stage of your startup and data available to you, the flow chart (below) will help you determine which valuation method is relevant for your startup.
1. Discounted Cash Flow (DCF) Method
The DCF method works well if your startup is already generating some revenue. You will be able to more accurately project future cash flows over the next few years. And the sum of all future cash flows is the present value of your startup.
One of the benefits of using the DCF method is that it takes into account the time value of money. That means that money today is worth more than the same amount in the future because of its potential earning capacity.
If you are projecting cash flows over N years, what will happen after that? You can calculate the Terminal Value (TV) of your startup in two ways.
Option 1: Business will keep growing at a steady rate.
TV = CFn (1+g) / (r-g)
CFn: cash flow at period N
r: discount rate
g: expected growth rate
Option 2: You will exit the business after N years.
TV = acquisition value / (1+r)^n
2. First Chicago Method
The First Chicago Method is an extension of the DCF method. The DCF valuations and probabilities for the best, normal, worst case scenarios are multiplied to get a weight average for each case.
3. The Berkus Method
The Berkus Method is a simple and convenient rule of thumb to estimate the value of a startup. There are several limitations to this method. Firstly, the method is used for startups that can reach US$20 million in revenue in 5 years. Secondly, the overly simplified method assumes that all startups are the same or will generate the same value.
For each factor, add up to $500K to your startup's value if the factor exists. With the Berkus Method, the maximum value of your startup is $2.5 million.
4. Risk Factor Summation (RFS) Method
The Risk Factor Summation Method is an extension of The Berkus Method. You determine the base value of your startup as per The Berkus Method, then adjust the value for the 12 risk factors (below).
Very Low: +$500K, Low: +$250K, Normal: 0, High: -$250K, Very High: -$500K
If the base value is $1 million, then the value of this startup will be $1 million + $250K = $1.25 million. The challenge of this method is to assess the risk level of these factors.
5. Scorecard Valuation (or Bill Payne) Method
The Scorecard Valuation Method used when you understand the strengths and weaknesses of your startup compared to your competitors. You start by using the Risk Factor Summation Method to determine a base value for your startup. Then adjust the value based on the weight average of the range and the performance vs competitors (target company).
If your company performance better than competitors for a specific criteria, then the target company score is above 100%. If its weaker than competitors, then the target company score is below 100%. Assuming that the base value is $1 million, the final value of this startup is $1 million X 1.0750 = $1.075 million.
6. Comparable Transactions Method
The Comparable Transactions Method is a simple method comparing the indicators of similar companies that have been sold or acquired. You need to retrieve information about selling prices and key indicators like sales, EBITDA or any indicator specific to your industry (e.g. subscribers for an online video streamlining business).
Using the median value of each multiplier for each indicator, the startup is worth between $1.20 to $1.60 million.
7. Venture Capital Method
The Venture Capital Method are common used by investors to quickly estimate the value of a startup. Investors often have a target exit price and return on investments (ROI) that they want from an investment.
For example, an investor may be looking for an ROI of 25X and exit price of US$100 million in 5 years.
Exit Price / Target ROI = Post-money valuation
$100M / 25x = $4M
And the entrepreneur is asking for $1 million in funding.
Post-money valuation - Amount Invested = Pre-money valuation (before dilution)
$4M - $1M = $3M
Now, we need to adjust the pre-money value for dilution. Assuming that the entrepreneur will obtain future funding and dilute the investor's stake by 25%.
$3M x 75% = $2.25M
And the valuation for this startup is $2.25 million after accounting for dilution.
8. Book Value Method
Book value is more of an accounting concept than a valuation method. We recommend that you use book value as one of the last options if you are unable to value your startup using the other methods.
The book value of a company refers to its tangible and intangible assets. But for a startup with no revenue and/or has not been sold in the market, it is very difficult to value intangible assets (e.g. patents, software, subscriber base). Thus, for this method, we only look at cost of tangible assets (e.g. building, equipment and inventory) minus depreciation.
9. Liquidation Value Method
Liquidation value is similar to book value but it is the cost at which your tangible assets can be sold when you go out of business. The liquidation value tends to be lower than the book value because the assets are sold under adverse conditions (fire sale). This method should only be used as the last option.
What's The Best Method?
Now that you understand the nine different methods to value a startup, which method is the best? The best method depends on the nature of your startup and the information you possess. Using a combination of methods and adjusting each method can help you achieve a more accurate valuation for your business.
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