Startup Valuation
It’s possible to bootstrap your way to success without ever needing outside investment, but it doesn’t hurt to know what your startup is worth.
Valuing any company is difficult because you need to be able to predict the future growth and the risk of competition to determine potential profits — and estimating the value of an early-stage startup is notoriously difficult.
Valuation of startups is an art, not a science and the answer frequently triangulates around a 20% ownership position for investors.
Paul Cohn, I’ve done VC stuff
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How startup valuation works
Raising capital is one of the most important tasks for any startup entrepreneur, and often the biggest challenge. Pitching your startup to potential investors will depend on the way you value your startup, so choosing the right methodology is essential for your success.
There are multiple methodologies for valuing startups, so it would be wise to choose depending on the stage your startup is in.
The key factors that go into startup valuation
Determining how much your startup is worth is a complex process, with many different variables to take into consideration. Sometimes there are little financial figures to show, and valuations depend more on industry characteristics. Here are some key factors that will help your startup get the most value.
Customer/User base
Having a strong customer base is essential for your startup’s success as it is a common proxy for revenue. Investors will want to invest in a business that generates revenue, so you need to show that your business has a loyal pool of clients or has a well defined plan to get there.
Growth Potential
Even if you have a good idea, strong customer base and low competition, you need to present investors with a vision for the future growth of the company. Where do you operate now and what are the markets you want to expand in? How scalable is your business? What are some future potential income streams? Make sure to ask yourself these questions, as a clear business plan will enhance your valuation.
Profitability
While turning profits is not essential for startups at the beginning, they are a definite goal in the medium to long term. You need to convince investors that your business will turn profits, rendering their investment with some nice returns.
Starting out: How investors value a business with no revenue
Even if you’re at the beginning, just came up with an idea and don’t have any revenues or team, there are ways to value your startup at inception.
It would be best to choose a lighter methodology as you don’t yet have any financial figures to show. Therefore, you should probably consider the basic valuation methods, like Venture Capital or Berkus.
Venture Capital Method
The venture capital method of valuing startups requires a good understanding of the market and comparable businesses. As the name suggests, it’s a valuation approach favoured by most venture capitalist.
How does the venture capital valuation method work?
Expected Return on Investment (RoI) = Exit Value / Post-money Valuation
which means
Post-money Valuation = Exit Value / Expected Return on Investment (RoI)
In this simple equation, let’s assume your startup is expected to achieve a £30mn exit within 5-8 years (the typical timeframe expected for early-stage ventures).
Post-money valuation: £30m / 30x = £1m
Pre-money valuation: £1m – £100,000 = £900,000
This means that if an investor is targeting a 30x return her portfolio — VC’s will usually aim for 10-40x — she would invest up to £100,000 at £1m post-money valuation.
Pre-Money vs. Post-Money Valuation
Pre-money and post-money is a simple concept, but it’s essential that founders understand it well.
Pre-money valuation is the value of the company before the financing round. Post-money valuation factors in the new investment(s) after the funding round.
So, post-money valuation = pre-money valuation + new funds raised. Simple!
Berkus Method
This method values a startup by taking into account five qualitative variables and assigning them a quantitative value.
- Sound Idea
- Prototype
- Management Team
- Strategic Relationships
- Sales
Investors can determine which value to assign to each item, let’s say £200,000 for each of the five qualities the startup possesses in full. For variables that are not 100% present in the startup, the investor may decrease the quantity attributed accordingly. Summing the amounts of each variable will determine the ultimate valuation of the startup.
Traction: Seed to Series A
Your idea is now starting to take shape, you have a team and maybe you’ve made some sales. Now you can use more complex methods to value your startup when pitching investors, such as Cost-to-Duplicate or Comparables Method.
They both involve taking into account the wider market, looking at competition and the strength of your idea relative to the wider industry. For this, you need to do your due diligence and be well informed about the market you want to operate in, potential competitors and businesses similar to yours.
Market comparison methods
Cost-to-Duplicate Method
The primary goal when using this method is to demonstrate that your startup would be very difficult to replicate, and therefore would have a higher chance for success given the high barriers to entry. Proving that competition is scarce in the business area your startup will operate is no easy task, and requires pretty heavy due diligence.
Essentially, the higher the competitive advantages of your startup, the higher its valuation will be. If it’s cheap for someone else to replicate your idea, that means it won’t be valued very high by investors.
Comparables Method
If the previous method implied others not being able to put your idea into practice, the comparables method implies scanning the market for startups similar to yours and checking their valuations. For example, if a startup was recently valued at $1mn and its has 1000 clients, then you could imply that the company was valued at $1000 per client. If your business model is similar, this benchmark can be used in valuing your startup.
Scale: Series B and beyond
At this point you have proven your business model, you’ve set up your startup and generated revenue. What you need is more capital to continue growing.
The recommended methods at this stage are a bit more technical and complex, as you have historical numbers and figures to play with and estimate the startup’s future earnings potential.
Methods such as the Discounted Cash Flow Model or using Valuation Multiples would be good options to present to potential investors, as they will expect a certain degree of financial analysis to help them make well informed investment decisions.
More complex valuation techniques
Discounted Cash Flow Model (DCF)
This is one of the most complex valuation methods, often used by financial analysts to calculate a business’ value. The methodology involves estimating a present value from discounting future cash flows at a chosen discount rate. You can check this website for more information on how to calculate valuations using this method.
Multiples method
This is a valuation method more commonly used for more mature startups that are already showing revenue and profit figures. It uses the company’s EBITDA, a financial performance metric which represents its earnings before interest, taxes, depreciation and amortization.
Investors can value the startup at 10x EBITDA for example, with 10 being the valuation multiple. The valuation multiple is determined based on the market, industry, competition, management and other factors.
Get a more accurate valuation…
It’s fine to use a rough estimate when you’re just getting started, but once you’re approaching investors you’ll want an impartial valuation to support your ask.
We recommend using Equidam, the leading online platform for startup valuation. More than 130,000 companies have already used Equidam to raise their seed and Series A rounds.
Equidam has created a unique platform to support founders to learn, monitor and grow their startup valuation. Equidam’s technology enables entrepreneurs to learn what drives their valuation, transparently discuss it, and close fair deals with investors.
Benefits of using Equidam
- Tailored to founders and startups
- More than just an estimate: open and grounded methodology
- Clear and detailed valuation reports
- Technical and financial customer support
- On the side of the entrepreneur, with an eye towards fair value