July 7, 2022
Thanks to globalization and the rise of the startup economy, there has never been a better time to start a business. Aspiring entrepreneurs can now leverage remote workers, crowdfunding platforms, automation software and so much more. It’s no wonder that in 2021 alone, a record 5.4 million companies were launched in the US.
On the other hand, the competition has never been this stiff. Only 30% of startups stay afloat for over five years, with 10% failing within 12 months of their launch date. The most common issue cited by failed CEOs is a lack of funding. Valuation is the one thing every new business must focus on, as it will determine your funding.
However, what makes a valuation successful? Which method is right for the pre-seed and seed rounds? How do you value a startup company with no revenue?
Lucky for you, this guide has all the answers you’re looking for.
Importance of an Accurate Valuation
Early-stage valuations can make or break a business. When it comes to startup valuation, honesty is the best policy. Both under and overvalued companies are likely to struggle with challenges that could be easily avoided with an accurate valuation.
If you value your business too low, you’re setting yourself up for some predictable issues:
- Heavy Dilution
Since your stock will be undervalued, you will likely have to offer a lot of equity to investors at the seed stage. That will in turn force you to dilute heavily your stock when it is time to raise further funding.
- Investor Fatigue
Most investors have a large portfolio of startups. For obvious reasons, their most valuable startups receive more attention than the rest. Investors are highly motivated to see their biggest ventures succeed, so they are less likely to prioritize businesses with low valuations.
- Low Sustainability of Liquidity
If your startup does well in the early stages, VCs and investors can provide Secondary Liquidity. In other words, they will offer to buy some more of your shares for a much-needed cash infusion. Companies with low valuations may not be able to afford the extra equity loss.
On the other hand, a too-high valuation poses significant risks as well:
- Talent Vacuum
When it’s time to scale up, you will want to hire the best staff available. However, the best talent out there is only attracted to startups because they offer equity as part of the compensation. They want to get in on the ground floor and watch their shares grow exponentially until they can cash out at an IPO or other liquidity event. If your startup receives a high valuation, the initial stock will be overpriced as well. That means any equity offered will have limited potential for further growth, and your hiring prospects will consider this.
- Unrealistic Milestones
A high-value company comes with even higher expectations. You will be expected to reach milestones that leave absolutely no room for error. If you fall behind – most overvalued startups eventually do – forget about keeping investors on board for another round of funding. f any major mistakes are made, you can even lose the CEO position at your own company.
- Difficulty Raising Further Funding
There is an unspoken rule among VCs – the current round needs to be at least double the last one. As such, if a company is overvalued during Round A funding, there is no going back to a fair valuation in round B.
- Less Lucrative End Game
The last stage of the startup lifecycle is known as the exit. Simply put, once your company becomes successful, you may want to sell it for a premium to cash out your remaining stock. However, if a company is overvalued, investors are less likely to sell because they’re only interested in high ROI rates. For example, with a valuation of $10B, selling for $15B gives you a 150% ROI. However, with a lower valuation of $3B, the return on investment becomes 500%.
How to Value a Startup - Top 7 Methods
Investors typically have a target IRR - Internal Rate of Return that they hope to generate from their investments. Based on your projections, you can take our IRR Calculator Spreadsheet and determine what your expected IRR might be based on your financial forecast.
Putting a dollar value on a business often involves complex formulas, painstaking calculations, and data processing. As any seasoned investor will tell you, startup valuation is more of an art than a science. There are too many variables to account for, including qualitative as opposed to quantitative. Can you possibly put a price on talent, teamwork, or vision? Well, it turns out you can.
Early Stage Startup Valuation Methods
#1 Scorecard Method
Created and popularized by investing heavyweight Bill Payne, the Scorecard Method is one of the most widely used valuation techniques. It determines a company’s value by examining similar businesses and adjusting their existing price according to a scorecard of factors.
To start, you need to calculate the average comparable value of startups in your business sector. This average acts as a benchmark. Meanwhile, the below factors determine if your startup is valued below, above, or on par with the average. Percentage values are assigned depending on the importance of each factor.
- Team Management - 30%
- Scale of Opportunity - 25%
- Product/Innovation - 15%
- Scale of Competition - 10%
- Marketing/PR - 10%
- Need for Further Investment - 5%
- Everything Else - 5%
According to Bill Payne, after you determine the average comparable value, an effective scorecard can be put together in four simple steps:
Step 1: Assign Scores
The above breakdown of the seven factors won’t be a perfect fit for every industry. If you know which aspects are most valuable in your business sector, reassign the percentage values accordingly. For example, an electric bike manufacturer should be focused on Product above all else.
Step 2: Rank the Startup for Each Factor
Review how your startup compares to the competition in each of the seven categories. If you are lagging in a category, estimate the size of the gap, and score your company appropriately. Likewise, if your team or product is ahead of the competition, make sure to reflect that on your scorecard.
Step 3: Sum Up and Convert Into a Dollar Value
Once you add up all your scores, convert the percentage value into a numerical one, where 1 = 100%. Then, multiply the result by the average comparable value you started with.
#2 Venture Capital Valuation
Venture Capital Valuation is the closest thing to a science-based approach to pre-money startups. First presented by Harvard Professor Bill Sahlman in 1987, this technique has helped value thousands of companies. The method is based on one simple formula:
Anticipated Return on Investment = Terminal Value / Post-Money Value
Here, the Terminal Value means the predicted selling price of the startup, assuming the sale will take place five-eight years down the line. The Terminal Value is determined by comparing sales prices of similar companies.
The Anticipated ROI is determined by investor expectations. The industry standard for expected ROI for early-stage startups ranges from 10 to 30 times, depending on the sector.
The equation can be rearranged to determine the Post-Money Value instead of ROI.
Post-money valuation = terminal value / anticipated ROI
From there, it is just a matter of plugging in the variables and calculating the projected value.
#3 The Dave Berkus Method
Dave Berkus is one of the most renowned angel investors of our time. He often credits the valuation method he created in the 1990s as the reason behind his success. The Berkus technique relies on five major deciding factors.
- The Idea
Does the startup have an exciting, innovative idea?
- The Management Team
Did the founder put together an effective management team?
- The Product/MVP
Do they have a product prototype that attracts customers’ attention?
- The Networking Strategy
Did they choose their strategic partners wisely? Is there an existing community made up of their target customers?
- Sales and Rollout Schedule
Did they present a solid, realistic rollout schedule? Have they made any sales?
Similar to the Scorecard Method, each category is evaluated separately and assigned a value. Their collective sum is the projected startup value.
Originally, each factor was assigned a maximum value of $500,000. However, for best results, you should adjust that number according to current trends in your sector. The easiest way to do so is to determine the average of the comparable value of similar startups, and then divide it by five.
How do you value a startup company with no revenue?
For best results, a combination of different methods should be used to value companies with no revenue. While no single method is guaranteed to be accurate when it comes to pre-money startups, the Risk-Factor Summation method provides the most precise numbers.
#4 Risk-Factor Summation
Like most pre-money valuation techniques, the Risk-Factor Summation Method requires you to start with an average comparable value. The twist is that instead of qualitative factors like Product Quality and Scope of Opportunity, this method employs 12 risk factors. These factors are:
- Management Risk
Are there any known issues that may influence the management team’s effectiveness?
- Startup Cycle Stage
Is the company in its earliest (and therefore riskiest) stage?
- Political Risk
Can potential changes to legislation impact business operations?
- Marketing Risk
How great is the company’s dependence on meeting marketing goals?
- Supply Chain Risk
How well-established are the supply chains the company uses?
- Future Funding Risk
How much capital will the startup require in future funding rounds? Is this a realistic amount that can be raised easily?
- Competitive Risk
How crowded is the business sector? What level of intensity do you expect from the competition?
- Litigation Risk
Is the company operating in a legislative gray area? How likely is it to be sued?
- Tech Risk
Will the idea remain viable if new technology is introduced to the market? How likely is new tech to make the company obsolete?
- International Relations Risk
Can geopolitical factors hinder the business? To what extent would a breakdown of international relations affect sales?
- Reputational Risk
How strong is the brand reputation, and what is the potential for losing that reputation?
- Exit Risk
Does the company have a potential exit goal? How likely is it that the company’s equity will be diluted before it is sold?
Late-Stage Startup Evaluation
Companies that have been in business for several years have the advantage of quantifiable data. With a proven record of metrics like sales, ROI, marketing spent, assets/liabilities, and growth, startups don’t have to rely solely on intuitive methods. Instead, established businesses can use methods based on cold, hard data.
When it comes to startup valuation revenue, multiple strategies stand out from the rest.
#5 DCF Method
The Discounted Cash Flow method requires you to painstakingly build a complex model in Excel. In return, it offers incredibly accurate results, complete with an analysis of multiple future scenarios. In addition, the best models can even give you a sensitivity analysis.
To create a DCF valuation model, you will first need to gather the below metrics.
- Tax Rate
- Discount Rate
- PGR (Perpetual Growth Rate)
- The EBITDA Multiple (Enterprise Value / annual EBITDA)
- Current Outstanding Shares
- Current Share Price
Not everyone is an Excel wiz. Luckily, everyone does have a simple alternative. Here at ProjectionHub, we specialize in helping startups get much-needed funding by creating accurate and reliable 5 year financial forecasts. Even if you want to perform your DCF analysis, our in-depth templates can simplify the process by eliminating the most boring, technical aspects of startup valuation. But for complex models we can also build custom models to be a perfect fit.
#6 Capitalization of Cash Flow Method
Also known as the Income Capitalization Approach, this method determines a company’s value by relying solely on past and projected income. The simplified formula looks like this:
Value = NOI (Net Operating Income) / Capitalization Rate
The Capitalization of Cash Flow method is best suited for companies that have a relatively steady projected growth rate. Like the DFC Method, it requires multiple quantitative inputs. These include the tax rate, EBITDA margin, total expenses, and pre-tax income rate.
#7 Asset Approach Method
The Asset Approach Method can be highly effective, but only in certain business sectors. It is based on the simple principle that the assets and liabilities of a business are the most important metric for valuation.
To perform Asset Approach analysis, start by listing your quarterly/annual liabilities, then subtracting them from assets in the same period. Some variations of the Asset Approach also require you to create models that predict future asset values.
The main reason most startups can’t be accurately evaluated using the Asset Approach is that the literal value of most startups can’t be measured in assets. A software company that employs remote teams may have minimal assets, even when revenue reaches into seven-figure territory.
That said, if your business sector implies the need for assets, there is no better way to value it. The most common types of businesses that can benefit from the Asset Approach are companies involved in manufacturing, logistics, or real estate.
What to Consider When Choosing a Valuation Model
Startup valuation is never an exact science. For best results, you should take the time to try out each approach and utilize at least two to three of them in your analysis. With so many options, determining the best methods for your company can be a headache. To simplify the process, focus on the most important determining aspects.
- Revenue Scope
There’s a huge difference between the value of a company that generates seven-figure revenue and a pre-money startup. What most people don’t realize is that below the $500,000 mark, revenue doesn’t make much of a difference at all. Most startups have enough ambition to project multi-billion dollar cash flows. Therefore, from an investor’s point of view, anything below seven figures is just not significant enough to take into account.
- Comparable Multiples
As you probably noticed, most valuation methods rely on a benchmark value. The only way to come up with that benchmark is to find valuations of similar startups in the same business sector. These are often referred to as Comparable Multiples. An ideal match should be based on historical data such as acquisition price, VC investments, and public stocks, among others.
- Diluted Shares
Dilution of shares may be the number one pitfall for startup founders. I It is such a common mistake that the series Silicon Valley based most of Season 2 on it, starting with the aptly named “Runaway Valuations” episode.
To avoid diluting your shares, make sure you use at least one or two of the more conservative valuation methods.
Pro Tip: VCs will often try to include so-called “Anti-Dilution Provisions” in your contract. Avoid them at all costs, as they protect the investors’ equity by sacrificing the founder’s stock value.
- Product Dev
Some methods are only applicable if you’re already in the prototype stage of product development. An MVP can often provide additional insight, acting as a placeholder for late-stage metrics like projected sales and assets/liabilities. Streamlining the product development process can provide an opportunity to value your startup using the most reliable approaches available.
It’s important to understand that there is no one-size-fits-all valuation strategy. However, by utilizing multiple methods, you can come up with an average value that encompasses all the deciding factors mentioned in our guide.
Remember to aim for an honest value, even when you’re tempted to exaggerate it. No matter how you look at it, the short-term benefits of a high valuation are simply not worth the long-term problems that will stem from it.
Most importantly, if the valuation process seems overwhelming, the best strategy may be to get assistance or outsource the process entirely. If you need help evaluating and funding your business, don’t hesitate to contact us at firstname.lastname@example.org and we can help point you in the right direction.