Startup Valuation Basics
Startups are a phenomenon of the age we live in. There have always been entrepreneurs, Henry Ford was one. However, startups are a fairly recent development. Twenty years ago no one discussed the latest startup valuation, let alone the latest startup.
Today, the world has thousands of startups, the biggest of which changed our lives fundamentally. Virgin, Google, Facebook, Alibaba, Tencent, Uber, Airbnb, Twitter, LinkedIn, Amazon, and many more all started out as startups. And every ambitious entrepreneur hopes to create the next big thing that will change the world.
To turn that vision into reality, a startup needs funding. Funding is based on the estimated value of a startup, which is a logical concept but not simple to execute. It’s tricky to assign a value to a business that’s just starting and has little or no sales and other data. So how is it done?
Factors that might justify a high-value estimate
- Plans to scale up – Investors want to see a plan to scale up and achieve high growth, otherwise, why should they invest?
- Customer base – An existing customer base or network of people who are already using and benefiting from what the startup has to offer.
- Prototype – There is nothing like an actual example of what a company aims to produce to impress prospective investors.
- Traction – How is the startup progressing? When was it founded and what has happened since? Has it gained any traction? Is it showing growth or growth potential?
- Brand value – If the startup’s brand is already recognizable, it’s a big feather in an entrepreneur’s cap.
- Previous funding success – Investors are more likely to invest in a startup that has had previous funding rounds that brought in money; it creates immediate faith in the founder(s).
- Revenue – Any investor will want to know what the planned revenue stream is. No one will invest in a venture that can’t show how it plans to make money.
- Choice of market – An already saturated market may offer few opportunities for growth, which is not an attractive prospect for investors. On the other hand, an exciting market that’s attracting a lot of interest amongst entrepreneurs and market insiders may be an attractive prospect.
- The investors – The investors themselves will affect the valuation of a startup. Different investors have different reasons for investing and different factors they look at before investing.
Factors that might reduce a startup’s valuation
- Management problems – If the management team shows signs of in-house conflicts, and an inability to put differences aside, or key positions have not been filled and the startup doesn’t have a high-value team, it will be difficult to get investors interested.
- Offering not proven – If the founder can’t show beyond doubt that the proposed product, process, or service is innovative, fills a need, and works, funding will not be forthcoming.
- Low margins – Some industries, like garden services or home healthcare services, have low margins, which may not be attractive for investors.
- Low market potential – The offering must be for a growing market, one that will potentially yield a large customer base. If the potential market is small, investors won’t be interested.
- No prototype – It’s better to have a rough prototype that people are already using than a detailed sketch of an idea.
- Competition – Too much competition may affect a startup’s market valuation.
- Founder desperation – If a founder is too desperate for money, they may value their undertaking too low with detrimental consequences for the business down the line.
Startup company valuation is important for both entrepreneurs and investors
Startup company valuation is important for the startup so founders can determine the amount of equity necessary to part with in exchange for funds. At the same time, the valuation will help investors determine the percentage of shares they will receive in return for their investment.
Entrepreneurs aim for a high valuation, while investors usually go for a discounted value with a promise of an excellent return on investment (ROI). What’s needed is a fair valuation.
Quoting a too high or too low valuation can have dire consequences for a startup. For instance, a higher figure than the actual value of the startup may lead to the entrepreneur agreeing to targets that the startup can’t meet. It will most likely result in a negative impression of the startup and a lower valuation in the next funding round.
On the other hand, a too low valuation is very risky. Many a founder has rued giving away too much equity too early because they undervalued their business.
Different funding rounds
Startups typically go through a series of funding rounds after the business has been developed to a point where it has outgrown the extent of the founder’s pocket and those of family and friends.
This is the first official funding round. Seed funding is employed to get a founding team together to undertake tasks like doing market research to determine its target demographic and to refine product development.
Depending on many different factors, this round may involve founders themselves, friends and family, and may even attract incubators and venture capital companies. Angel investors commonly invest at this stage.
Seed funding rounds can generate anything between $10,000 and $2 million for a new startup.
Series A funding
To obtain Series A funding, a startup must demonstrate a strong strategy for turning its product, service, or process into a money-making machine. A startup may use these funds to further refine its offering, try it out in additional markets and establish a firm user base.
Traditional venture capital firms usually get involved in this round, with one often taking the lead and others following. This round tends to generate between $2 and $15 million.
Series B funding
At this stage, a company has a proven customer base and needs help to expand it and get ready for business on a large scale. Funds are used to grow the business, hire top business development talent and employees for sales, advertising, tech, and customer support. A series B round averages $33 million.
Series C funding round
Companies that make it to this round are already successful. The funds acquired at this stage are employed to expand the company’s offerings, to enter new markets or to acquire other companies. One way to scale a business is to acquire a company with a competitive advantage that may benefit the startup.
This stage usually attracts a different class of investors, such as hedge funds, investment banks, and private equity firms that can invest huge sums. They are prepared to make significant investments because startups at this stage have already proven their worth.
Startups typically attract hundreds of millions of dollars at this stage, and their valuation may be $100 million or more. A successful series C funding round can boost a company’s valuation well beyond $1 billion and more these days.
Startup valuation methods
This method looks at how much it would cost to set up a similar business from scratch. This approach usually looks at the hard assets of a business and tries to determine a fair market value for them. The shortcoming of this approach is that it leaves out other important aspects of a business, such as its potential to generate future income and assets like brand recognition or the founder’s leadership ability and vision. Most people agree that this approach generally leads to an undervaluation of the business.
- Market multiple
On the face of it, this seems a simple approach: looking at the price that similar undertakings fetched recently. This approach is popular with venture capital investors because they get a real indication of what the market is willing to pay for a similar company.
For instance, if a wearable tech company was sold for $18 million and it had 500,000 users for its wristband. That comes to $36 per user. A founder could use that as a basis for working out the company’s value, adjusting up or down to make allowances for differences in the product, etc. If the company has 600,000 users, the value would be roughly $21 million.
One drawback of this method is the relative incomparability of different startups and their offerings. It may also be challenging to discover any relevant figures related to a recent acquisition deal.
- Discounted cash flow (DCF)
This method takes the forecasted future cash flows and then applies a discount rate, or the expected rate of return on investment (ROI). For this method to work, the founder must find a talented analyst that has exceptional abilities to forecast future market conditions and future growth rates.
For example, an investor may expect a 10% return in a year on his investment, in which case the discount rate would be 10%. The discount rate is an indication of the risk involved – a higher discount rate would mean a higher risk.
One disadvantage of this method is the fact that it’s virtually impossible to project sales and earnings potential beyond a few years.
- Post-money valuation
Post-money valuation is the value of a company after it has received some financing during a funding round from venture capitalists or angel investors. This amount is then added to the company’s balance sheet.
Valuations before these funds are added, are called pre-money valuations. So, the post-money valuation is simply the pre-money valuation plus the amount of funds received from investors.
The investor’s portion of the company is calculated according to the investment amount. Investopedia gives a simplified example: if a company has a $100 million pre-money valuation, and an investor invests $25 million, the post-money valuation would be R100 million plus R25 million. The investor would own 20% of the $125 million company.
- The Berkus method
The Berkus method assigns a monetary value to specific success metrics, such as:
- A sound idea
- A prototype
- Quality management team
- Strategic relationships
- Product rollout or sales
For each metric, if it exists, up to $500,000 is added. If it is not fully developed, a lower value could be assigned.
- Valuation according to development stage
This is company valuation according to the commercial development of a company. Compared to the earlier stages, a company that has developed along several stages will be less risky to invest in and will be more valuable. An example of valuations and stages:
|Stage of Development||Estimated Company Value|
|Strong business idea or business plan||$250,000 – $500,000|
|Strong, and capable management team||$500,000 – $1 million|
|Final product/service/process in place||$1 million – $2 million|
|Strategic alliances or network or beginnings of a customer base||$2 million – $5 million|
|Revenue is growing, profitability not in doubt||$5 million plus|
This is just an example. Actual valuations will differ according to the business and the investor’s valuation. In the beginning stages, the startup will have a lower valuation, but as it reaches subsequent milestones, the valuation will increase with investors providing more funding at each stage. For instance, in the beginning stages, the funding may be utilized to hire additional employees to help develop the product or service. Once that has been completed successfully, the next round of funding may help the company to market its offering.
- Risk factor summation method
This method uses one of the other methods to create a starting point for a valuation and then takes it a step further by figuring risk factors in. For each risk factor $250,000 is added or subtracted.
For low-risk factors, double the amount ($500,000) is added, and for high-risk factors, double the amount ($500,000) is subtracted from the valuation. For average risk, the figure stays $250,000.
The risk factors include aspects that relate to politics, manufacture, competition, technology, legislation, marketing, funding, international risk, and potential lucrative exit.
What a valuation estimate comes down to
Since very few founders can finance their undertakings indefinitely, most will come to a point where it becomes necessary to calculate a valuation estimate in order to secure funding. We discussed some of the valuation methods commonly used, and none of them are perfect. In fact, entrepreneurs often use more than one method to arrive at a valuation. Especially in the early stages of a venture, any attempt at valuation, no matter what method is used, involves a degree of guessing. Since this is the case, it often takes many discussions between founders and potential investors to come to a final agreement on the valuation of the startup.