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Nine Popular Methods for Realistic Valuation of Start-ups

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Ignoring the economics of running a business and its perceived value is as good as missing the main ingredient in the dish!

For an early stage start-up, it may be true that the odds of making great revenue are lower during the initial years to determine the true financial worth of the business.  But, a smart business owner who is aiming for longevity looks beyond the numbers earned initially, and taps into his network of VCs, investors, Angel investors, industry experts and competitors to find out the appropriate valuation method.

Realistic valuation of start-ups is important to avoid assumptions that lead to undervaluing or even setting very high expectations. Selecting the right method for start-up valuation starts with asking important questions like:

  • What makes my start-up idea unique?
  • Will my business or products gain traction?
  • What are its benefits to the consumers?
  • Does my company have any intellectual property which is not well-articulated as numbers?
  • How does my team comprising of talent with diverse industry experience and business acumen affect valuation?
  • What is about my start-up that’s pushing VCs and investors to neck and neck horse race?
  • What is the capital investment required to run this start-up?

After the first few stages of understanding where your business stands based on the responses you find for the questions above, it is important to note that different valuation methods are applicable in different start-up situations. However, these methods are commonly used to arrive at true value of business at the nascent (pre-revenue) stage:

The VC Method: This valuation method is adopted in valuation of start-ups that are still at the pre-revenue stage.  It involves formula-based calculation to arrive at the return on investment (ROI) and post money valuation.

ROI= Harvest Value /Post Money Valuation.

Harvest value is the future selling price based on reasonable expectation on revenue from sales and projected earnings.

Post Money Valuation = Harvest Value / Anticipated ROI.

 

Berkus Method: Designed by a well-known author of the book, Winning Angels and Angel investor, Dave Berkus, the method assigns a value for the milestones reached by the start-up based on five key criteria:

Sound idea (Basic Value)                                        $1/2 Mn

Prototype (technology)                                           $1/2 Mn

Quality management team (execution)               $1/2 Mn

Strategic relations (go-to-market)                         $1/2 Mn

Product rollout or Sales                                          $1/2 Mn

Scorecard Valuation Method: As its name suggests, scorecard valuation method keeps a scorecard with values of other Angel-funded start-up and businesses in the similar group or industry to find the pre-money valuation of the company.  This method starts with identifying average pre-valuation of pre-revenue companies in different regions and areas,  and their pre-money valuation differs according to competition and economic conditions prevailing in the region.  This is followed by using the scorecard to draw comparison between the start-up or business with the ones  in the region as per the below mentioned parameters:

  • Strength of the Management Team 0-30%
  • Size of the Opportunity 0-25%
  • Product/Technology 0-15%
  • Competitive Environment 0-10%
  • Marketing/Sales Channels/Partnerships 0-10%
  • Need for Additional Investment 0 – 5%
  • Other 0 – 5%

To calculate the valuation amount, a factor value is assigned to each of the parameter of the start-up and the sum total of the factor value is then multiplied to the average pre-money valuation.

 

Risk Factor Summation Method: Risk factor summation method is takes into consideration 12 risk factors to compare the start-up to its projected fundable and profitable version by using the average pre-money valuation of start-ups in the region and area as given in the scorecard valuation method. Those 12 risk factors are:

  • Management Risk
  • Stage of Business
  • Legal/Political Risk
  • Manufacturing Risk
  • Sales Risk
  • Funding and Capital Raising Risk
  • Competition Risk
  • Technology Risk
  • Litigation Risk
  • International Risk
  • Reputation Risk
  • Potential Lucrative Exit

Comparable Transaction Method: The method involves comparing the valuation of start-ups in the similar field and using ratios and multipliers for elements where the two start-ups show different numbers.  To understand better, consider the below example.

An e-Commerce start-up is valued at 8,000,000 USD  and has a customer base of over 250,000. The cost of the company per user is the amount 32 USD.  Another similar start-up with 1,000,000 users will valued at 3,200,000 USD (multiplying company value per user i.e 32 USD with 1,000,000 users).

Book Value Method: Book value method considers all the tangible assets of the start-up to find it intrinsic financial value. But the issue with this method is that start-ups do not have fixed tangible assets at the pre-revenue stage and therefore, VC and investors look at the intangible aspects of the start-ups such as intellectual property, user base, research and more.

First Chicago Method: First Chicago method includes ‘what ifs’ to make evaluations for a start-up—worst case scenario, normal case scenario and best case scenario. The problem with this method is that it is well-applicable for start-ups that have crossed its revenue earning stage.

Liquidation Value Method: When a business is being sold to a buyer, its value is determined according to the liquidation value of its tangible assets and does not include intangible assets like copyrights, patent, good will and other intellectual property. Companies with higher liquidation amount imply lesser risk as the investors can make up for the losses by dissolving the assets in case the business files for bankruptcy.

Discounted Cash Flow Method: This method of valuing a company involves time value of money. The current value of the business is calculated by adding the cash flows in the upcoming years and discounted with by cost of the capital to arrive at the present value. The discounted cash flow method is applicable in valuation of start-ups and businesses that have reached the post revenue stage.

Start-up valuation is important for funding and provides insights on why the investors and VCs should take interest in the business and evaluate impending financial risks before investing.

Unlike businesses that have crossed its start-up stage, with many years of revenue earnings and profits, start-ups before the funding stage do not have tangible evidence to confidently approach investors and boost strap their firm. Mature business models that are listed out to potential buyers and investors evaluate their net worth using the EBITDA formula (earnings before interest, tax, depreciation and amortization).

But time and again, start-ups have proven that predicting their survival rate and success based on the valuation methods alone is impossible due to a host of changing variables like the economy, changing needs of their target audience, trends and changing market conditions. Nevertheless, adopting valuation methods is better than guesswork.

If you have more questions on valuation of start-ups and analysis required to assess it fundraising possibilities, visit our site for more details.

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