Startup valuation is more art than science, with science being the easy part. The art of a startup valuation is more subjective and includes the team's strength, the probability of leads in the pipeline, and how innovative the technology is.
Whereas science involves research and creating value for the startup using different methods and techniques.
It's not an easy task to value a startup that is yet to bring in revenue. Since the startup has no income, the traditional methods used to value a company will not work.
Normally, businesses are valued based on quantitative analysis, financial statements, and future projections- which can't be used to value a pre-revenue startup.
It can be a complicated process to value a pre-revenue startup as it requires a degree of subjectivity and experience. It's difficult to calculate the exact value of a pre-revenue startup in its initial stages- which is why the knowledge of how to calculate the valuation of a startup is important.
What is a Startup Valuation
A startup valuation provides insight into a company's ability to use the new capital to grow and meet the expectations of both customers and investors. The process is based on both tangible and intangible assets.
Founders and investors use different metrics to make a near-exact estimation, while analysts focus on the growth potential of the startup as well. Startup valuations can be a tricky process, as a lot is based on industry benchmark comparisons and projections, especially if the startup is in its early stage.
What Factors Influence the Valuation of a Startup
The founders of a startup are the face of their company. Investors look for experienced and reliable founders that have a diverse skill set in order to holistically grow their company.
For instance, founders with entrepreneurial experience are an asset. Thus, a startup valuation will be calculated higher if the founding team is experienced, skilled, and committed.
Investors look for product adaptability as a startup doesn't have much to show in terms of revenue. The more users there are, the better it is.
At this stage, a dynamic cost-effective marketing strategy is essential. Investors are more likely to fund a startup if they're convinced about its growth potential on a limited budget.
This indicates to the investor that there will be a higher ROI. Hence, a business idea that's viable and scalable, will increase the startup valuation.
Minimum Viable Product
The valuation of a startup increases considerably if it has managed to create an MVP with early adopters to show. No matter how great a business idea is, a minimum viable product is a complete game-changer in a startup.
Presently, the startup marketplace is primarily dominated by the tech and AI industries- this is where the money is. Investors value two things: a profitable industry and the demand for the product and/or service.
Unless a startup promises a high-profit margin, its valuation will decrease- even if the above four factors show as high. Investors all have a primary agenda in mind- quick profits and higher ROI.
What Is the Difference Between a Startup and Mature Business Valuation
A mature business valuation dramatically reduces the uncertainty that comes with investing in a startup. Mature business valuations are still considered science as more information becomes available.
The process still involves a high degree of judgment as all valuations are forward-looking. Companies at this stage are grown and generate revenue.
On the other hand, startup company valuation isn't based on set standards but leading practices. Companies at this stage are currently at a pre-revenue stage.
Consequently, startup founders will hope for a high valuation while investors hope for a bigger ROI. While startup valuations can’t rely on revenue and profit, other key factors can be considered in the process.
The method used in a startup valuation is based on the position of the startup in its lifecycle.
There are five initial funding stages:
Pre-seed Funding Stage
This is the stage where startup companies raise small amounts of money, typically from personal savings, credit cards, or friends and family.
This stage refers to founders getting their startup operations off the ground using their or close friends' resources.
During the pre-seed stage, a startup investment is between $10,000 to $100,000.
Seed Funding Stage
The seed funding stage is when a startup begins to raise money from external investors. This is where startup valuations start to get more creative as there's no revenue or profit to base it on.
The most common type of investors during the seed stage are startup accelerator programs, angel investors and micro VCs. Since the stakes are high at this stage, startup founders must give investors a high equity stake in the company.
During the seed stage, a startup investment is between $100,000 to $1 million.
Series A Funding Stage
Series A, or Round A is typically the first round of venture capital financing. By now, the startup definitely has an MVP, a customer base, and an initial revenue.
At this stage, it's time for the startup to optimize its value offerings and scale itself across different markets.
This is the stage where the 30-10-2 rule must be followed in order to secure investments between $2,000,000 and $15,000,000.
The 30-10-2 rule is a model relating to the ratio of investors interested in a startup. Of 30 potential investors, 10 are likely to want to meet, and of the 10 around 2 investors will proceed with funding the startup.
Series B Funding Stage
By Series B, or Round B a startup has proved its business viability and that it can achieve success on a larger scale. At this stage, the startup aims to expand its activity based on established business models in order to grow and meet the various demands of its customers and market.
The investment backing stage in Series B is in the range of $15,000,000 and $30,000,000.
Series C Funding Stage
At the Series C stage, startups generate multi-million dollars in revenue. These startups now aim to scale up in order to reach new markets, build new products, and even acquire other startups that are underperforming in the same market.
At this stage, advanced valuation models and metrics are needed to estimate the startup valuation. In the Series C stage, the focus is for the startup to scale as rapidly as possible.
Investors happily fund successful startups between $30,000,000 and $50,000,000 in this stage.
Angel Investors VS Venture Capital Firm Valuation Mindset
Both angel investors and venture capital firms invest money into startups, and both take risks when investing in hopes of earning a healthy ROI.
The difference between angel investors and venture capital firms is the when they participate in the startup fundraising efforts, the amount of money they invest and the risk they are taking.
Angel investors use their own money to invest in startups - they are usually family and friends of the founders. They tend to invest between $50K-$500K in the early stages of the startup thus assuming a higher risk.
On the other hand, venture capital firms invest in startups using money from investment companies, large corporations and pension funds. They tend to invest $3M+ and at a later stage when the startup already has more validation of the product-market fit.
How Much Money You Should Raise
Calculating how much money you should raise is crucial for the planning, growth, and success of your startup.
The answer to this question is: it depends. It depends on the startup's burn rate, which is the pace at which a startup uses up its capital.
Burn rate, otherwise known as negative cash flow, is the pace at which startups spend money before reaching profitability. Burn rate is often calculated by month, with overhead and variable expenses being included in the calculation.
The typical startup burns through $50,000 to $250,000 per month. The amount of money raised in the round should be enough to cover the startup's burn rate for 12 to 18 months. This allows the startup to achieve certain milestones and raise more money in future funding rounds.
For example, if a startup has a burn rate of $100,000 per month, they would need to raise a minimum of $1.2 million to have enough cash to last them 12 months.
The Process of a Typical Valuation Process
Typically, a valuation process may include a startup's capital structure, an analysis of the founders and management, the market value of its assets or its future earning prospects.
The tools used to calculate the value of a startup vary. However, the most common tools used include company comparisons, cash flow models, and financial statements.
The valuation process is also very important for tax reporting with the IRS (The Internal Revenue Service) which requires a business to be valued based on fair market value.
This is because some tax-related events to businesses will be taxed based on valuation, including the sale, purchase, and gifting of shares.
5 Ways to Value a Pre-Revenue Startup
First Chicago Method
The First Chicago method bases its valuation on the predicted cash flows of the pre-revenue startup. The profit that could be earned by investments is taken into account with this method.
Effectively, the First Chicago method is a discounted cash flow model. The cash flow model makes three financial projections: best-case, mid-case, and worst-case.
The startup's value is then calculated by discounting the net present value of the cash flows in each scenario.
The First Chicago method is best used when estimating the value of a startup with a long runway or large addressable market and has been used by some of the most successful startups, such as Airbnb, Uber, and Pinterest.
The Scorecard method values a pre-revenue startup by using other businesses in the same region and industry to compare and conclude an estimation.
For instance, if a similar startup was recently valued at $5 million, then the startup should be worth the same. The startup's value is then adjusted based on other factors such as capital, competitors, size, the product or tech, sales and marketing, the management team, and more.
This method is most commonly used when a startup doesn't have much data to go off of or there aren't many precedents in the industry.
The Berkus method values a startup by simple estimation. This estimation is done by envisioning the startup breaking $20 million in revenue by its fifth year.
It's done by assigning an amount of up to $500,000 to five different company aspects including its concept, the MVP, quality management, connections, and a launch plan.
Meaning, that the highest possible valuation using this method is $2.5 million. The Berkus method is useful to gauge the value and is especially used for tech startups. However, as this method doesn't take the market into account, the valuation may not provide the desired level of accuracy.
Venture Capital Method
The Venture Capital Method is an essential pre-revenue startup valuation. This valuation is done by projecting the future revenue of the startup in the next five years. Many assumptions are involved here and the formula used to make this calculation is:
Exit Value / Expected Return on Investment = Post-Money Valuation
Post-Money Valuation - Investment Amount = Pre-Money Valuation
For instance, if an investor has an agreed value of $10M and expects a 10x return on investment- then the post-money valuation will be $10M divided by 10, i.e $1M.
If an investor funds the startup with $2.5M for 25% ownership interest- then the pre-money valuation will be $7.5M.
Risk Factor Summation Method
The Risk Factor Summation Method combines aspects from both the Scorecard Method and the Berkus Method- resulting in a more detailed valuation focusing on the risks involved with the investment.
A total of 12 risk factors are studied, which either add or subtract monetary value on a scale that ranges from very low risk to very high risk.
For instance, -2 and -1 would be considered very high risk - resulting in the deduction of $500,000 and $250,000 respectively.
While +1 and +2 would be considered very low risk- resulting in an increase of $250,000 and $500,000 respectively.
0 is considered neutral, there is no deduction or increase.
The main risk factors in this method include the business stage, funding, technology, sales and marketing, management, competitors, reputation, global risk, legislation, potential exit, and litigation.
8 Common Startup Valuation Mistakes
1. Too Many Founders
Most startups generally have two founders, and occasionally there are three founders. Startups with two founders are more likely to complete a round of funding, and much faster than those startups with one or three founders.
If a startup has four founders, it's simply too many as the potential for the founders to fall-out is much higher.
In "The Founder's Dilemma", Noam Wasserman state's that the more founders there are, the higher the risk of coordination costs and inefficiency. Founding teams of more than three founders slows things down, weakens incentives and increases the probability of conflict within the team of founders.
2. Setting Too High or Too Low Valuation
One of the most common startup mistakes is setting too high or too low a valuation. If you raise funds for your startup with a low valuation you might be in trouble. This is because low valuation benefits the investor by giving them a bigger equity stake in the company.
However, your startup could also suffer from an overly high valuation which may lead to the wrong kind of investor and damage your startup long-term. A good valuation leaves both the founder and the investor satisfied, but not overly happy, as it often requires a compromise by both parties.
3. Raising Funding Too Early or Too Late
Timing is everything, and raising funding too early or too late are both horrible for a startup. The best time to raise funding has to be evaluated, but as a rule of thumb- funding should be raised every six to eight months each time.
4. Overlooking the Value of IP
In the early stages of a startup, it's easy to overlook the value of intellectual property (IP). This is because a lot of startups are focused on getting their product or service to market as quickly as possible, rather than taking the time to file for patents or trademarks.
However, if your startup has developed a unique technology or has a strong brand, IP can be one of your most valuable assets.
5. Not Considering the Value of Data
In the age of big data, startups that have access to large amounts of data can be extremely valuable. If your startup is generating a lot of data, make sure to factor this into your valuation.
6. Not Understanding Your Cap Table
Your cap table is a critical tool for understanding the ownership structure of your startup. If you don't have a clear understanding of your cap table, it's very easy to make mistakes when valuing your company.
Make sure you understand how much each shareholder owns, and what percentage of the company they own, before you begin your valuation.
7. Assuming All Investors are Equal
Not all investors are created equal. Some investors, such as venture capitalists, bring more than just money to the table. They also bring valuable experience and networks that can help your startup grow.
When valuing your startup, make sure to take into account the value of these non-monetary contributions.
8. Overlooking Potential Risks
When valuing a startup, it's important to consider potential risks that could impact the future success of the company. For example, if your startup is heavily reliant on one key customer or supplier, what would happen if that relationship were to sour? Make sure to factor in these types of risks when valuing your startup.
A startup's pre-money valuation is the value of the startup before any money is invested into it. This number calculates how much equity an investor will receive in exchange for their investment.
For example, if a startup has a pre-money valuation of $5 million and an investor invests $1 million into the company, the startup's post-money valuation would be $6 million. The investor would own 16.7% of the company (1 million/6 million).
A startup's runway is the amount of time that a startup has to achieve certain milestones before it runs out of money. For example, if a startup has a burn rate of $100,000 per month and it has $1 million in the bank, the startup's runway would be 10 months.
A startup valuation multiple is the ratio of the startup's post-money valuation to its annualized revenues (ARR). For example, if a startup has a post-money valuation of $6 million and it generated $1 million in revenue last year, its valuation multiple would be 6x.
The higher a startup's valuation multiple , the more risky it is for investors. This is because investors are paying a higher price for each dollar of revenue that the startup generates.
There are many reasons why a startup should have a valuation, including appeal, credibility, negotiation, and capability of acquisitions- all of which have a direct impact on the business and its future growth and profits.
Oftentimes, startup valuations require information from competitors to determine the startup's value.
That said, investors often look to competitors and other businesses in the same market to understand how a startup fits best into this landscape.
Investors will often look at pre-money valuations, funding rounds, financials, and how much those businesses have raised.
Lastly, there isn't a single valuation method that's 100% accurate. Most likely, various methods and techniques will be used to arrive at a reasonable ballpark value for a startup.