What Is Startup Valuation? – Understanding, Important, and More

What Is Startup Valuation?

Startup valuation is simply the value of a startup business, taking into account the industry’s market forces and sector in which that business belongs.

These factors include the balance (or imbalance) between demand and supply of money, the size of recent events, investors’ willingness to pay premiums to invest in the company, and the company’s level of need for money.

Understanding Startup Valuation

• To receive funding from external sources such as angel investors, VCs, or a group of investors, startups need to figure out the total amount of capital they need.
• In simple terms, startup valuation works to quantify the worth of the startup or startup idea.
• Startup valuation is one of the most significant parts of any fundraising process. While investing in a startup, investors exchange an amount of equity in the company.
• This is where the role of startup valuation comes into the picture. Fundamentally, the process of valuation removes the guesswork and presents the estimated value of the startup.
• Usually, new founders lack knowledge of evaluating the startup. Some founders quote a high figure to the investors even when they are at the pre-revenue generation stage.
• Simultaneously, few founders quote a lower amount even if they have a winning idea and potentially disrupt the market.
• Thus, the imperative is to understand the fundamental methods that are useful in the startup valuation process.

Why Is Startup Valuation Important?

1. Valuation matters to business owners because it decides the company’s share that they have to give away to an investor in exchange for money. The higher the company’s valuation, the less company needs to give to an investor in terms of shares and equity in the business or more money in an investment they are likely to receive.
2. A company’s value at the start or ‘seed’ stage will be close to zero with a startup. However, the valuation will be higher than that because you have to factor in growth potential to get investors to part with their cash.
3. For example, a startup trying to secure ‘seed’ investment will offer 10 per cent of the company for $100,000.
4. It values the company at $1,000,000, but that doesn’t necessarily mean it is worth $1,000,000.
5. Still, the startup is suggesting to the investor that there is a potential for the company to be worth figure after growth and investment.
6. Valuation is also important to investors. It is the main factor that suggests how much of a return they will get on their investment.

Methods of Startup Valuation

Valuation methods are significant, especially for early-stage startups when they are at the pre-revenue stage. These startups usually do not have any hard facts or figures to base the value of the business. Hence, there comes the need for predefined valuation methods.

The well-known startup valuation methods are:

1. Berkus Method

• This method is one of the simplest, created by Dave Berkus,  an American venture capital expert.  This method assigns $0.5 million to various factors as the startup begins to make progress.
• It describes five key elements: sound idea, prototype, quality of management team, strategic relationship, strategic partnerships, and product rollout or sales to determine the startup value in a range of $0-2.5 million.
• This method is only valid for pre-revenue companies.

2. Scorecard Method

• This method uses the valuation assigned to an already angel-funded company. It begins with finding a company of a similar stage operating in the same geography and same domain.
• After getting its average pre-money valuation, the startup is thoroughly analyzed to find its strengths and weaknesses.
• And also, it is given weightage to various factors such as the size of the opportunity, technology/ product, management strength, competitive environment, marketing, funding requirement, etc.

3. Risk Factor Summation Method

• This method works as a combination of the Berkus and Scorecard process while emphasizing the risk factors.
• Various types of risks associated with the investment are categorized to assign grades to each category.
• The significant risk categories include management, business stage, sales and marketing risk, funding requirement, competition, technology, litigation, international and reputation risk, and potentially lucrative exit.

4. Venture Capital Method

• This startup valuation method emphasizes the exit or the terminal value of the startup. In this method, the investors consider the expected future returns of the startup.
• And also, it is one of the most effective methods, making it easier to estimate a potential exit value once certain target milestones are achieved.

5. First Chicago Method

• This method was first developed by and consequently named for the First Chicago Bank’s venture capital arm.
• And also, it is a business valuation approach used by venture capital and private equity investors.
• This method combines elements of both multiple based valuation and cashflow based methods. First, Chicago helps the investors to understand how viable and ambitious the startup plan is.
• This method focuses on three different scenarios: best case, typical case and worst case.
• Carrying out startup valuation, choosing the proper method benefits the investor as well as the founder.
• And also, it provides better knowledge of the company’s assets, resale value, and the company’s actual value.
• It further helps at mergers and acquisitions and raises funds to realise its future business plans and goals.

What Will Reduce A Startup Valuation?

An investor will not pay a premium or may not even invest if a startup contains or shows the following:

Poor Industry

• And also, a startup is in an industry that has recently shown poor performance or maybe dying off.

Low Margins

• Some startups will be in industries or sell products that have low-margins, making an investment less desirable.

Competition

Some industry sectors have a lot of competition or other business that has cornered the market. A startup that might be competing in this situation is likely to put off investors.

Management Not Up To Scratch

• If the management team has no track record or reputation, or critical positions are missing.

Product

• If the product doesn’t work, or has no traction and doesn’t seem to be famous or a good idea.

Desperation

• If the business owner is seeking investment because they are close to running out of cash.

Conclusion

Several startup valuation methods are available for use by financial analysts. Below, we will discuss some widespread methods used for valuing startups.

Startups, in the most general sense, are new business ventures started up by an entrepreneur. They usually focus on developing unique ideas or technologies and introducing them into the market in a new product or service.

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