The Most Prevalent Startup Valuation Methods
In the previous articles, we examined the marketing methods of startups. In this article, we try to discuss startup valuation methods. Valuation is a process that determines the characteristics and terms of the transaction between the investor and the startup founders. Startup valuation methods are diverse, but they can be divided into four main categories. However, the essential factor in determining the value of a startup is its growth potential in the future.
Methods of valuing startups
With the help of particular methods, we can obtain the value of a startup. Due to the differences in the hypotheses of each approach, the valuation figure obtained in different ways can be different from others. Therefore, accurate valuation of a startup requires knowledge, expertise, and experience to consider all aspects of the startup, its field of activity, macroeconomic status, etc.
In the following, we introduce the valuation methods of startups. Furthermore, we express the application of each along with the advantages and disadvantages.
However, the use of any of the methods of valuing startups depends on the stage of startup development.
Bill Payne has developed the scoring card method. It is a comparative method to find the value of active startups in the early stages. In this method, the investor evaluates each startup based on seven main factors; a certain weight and points are awarded to each element. These factors, along with the suggested weight of each, are as follows:
- The startup management team/founders: weight 30%
- Startup Opportunity Size: Weight 25%
- Product / Technology: Weight 15%
- Competitive environment: weight 10%
- Sales and marketing channels: Weight 10%
- Need to raise more capital: Weight 5%
- other factors such as customer feedback: 5% weight.
As it turns out, more important factors – such as the management team – weigh more than others. To evaluate a startup, it is enough to score these several factors and calculate the sum of each factor score multiplied by the weight to obtain the value of the desired startup based on the average valuation of active startups in the seed stage. For example, if the score (the sum of factors score multiplied by the weight) for a startup is 80% and the average valuation of startups in the seed stage is $1.5 M, the startup’s value in question is $1.2 M.
Given that the Scorecard Method is entirely qualitative and comparative, the most common use of this technique is to find the value of seed-stage or early stages startups by accelerators or angel investors. As startups in the early stages have not yet generated revenue and do not have much historical information, they cannot be valued using other methods.
One of the advantages of valuing a startup using the scoring card method is considering each of the various factors to find approximate value. Another advantage of this method is its speed and simplicity.
This scoring method is quite qualitative, and people may give different scores to a startup. Therefore, in this case, the scoring card will not be accurate for startup valuation.
Cost to Duplicate Method
In this method, you can assume that the value of a startup is equal to all the costs that the founder has spent so far to start and maintain the business. Of course, this valuation method is generally for startups that are likely to fail, and the founders intend to sell it. The basic logic of this method is that an investor is not willing to pay much cost to invest in a startup that does not have suitable conditions.
The costs incurred in setting up a company are generally converted into company assets; Land, buildings, offices, equipment, servers, intellectual property, etc., are all part of the company’s assets. Therefore, to find the re-establishing cost of a startup, one can obtain its assets’ value. Calculating the exact value of startup assets is a major challenge in this approach, especially when the startup does not have many tangible assets.
It is reliable because the ‘Cost to duplicate method’ is based on historical documents and data. This method is commonly a starting point for estimating the value of startups in the seed or early stages. Of course, as mentioned, it is less common to use this method for investing. It is more common to calculate a startup’s purchase value in critical situations.
The advantage of the Cost to duplicate method is that the investor can use it to calculate the minimum value of a startup.
The biggest drawback of this method is ignoring the startup growth potential and its profitability in the future. On the other hand, in this method, a lot of weight is assigned to the tangible assets of the startup (land, equipment, etc.) and the value of intangible assets (such as brand value) is not counted.
Dave Berkus method
As its name implies, this method was invented in 1990 by Dave Berkus, one of the most successful angel investors. In this way, without the need for startup financial forecast information, the investor can estimate its value experimentally by evaluating several key startup indicators. These indicators include the following:
- Product prototype
- Management team
- Strategic Partnerships
If a startup excels in any of these metrics, a maximum of $ 0.5 million will be added to its value. So if a startup is strong in all five of these indicators, it will be worth $ 2.5 million. Otherwise, it will receive between $ 0 and $ 0.5 million per value index.
The main application of this method is to evaluate startups that have not yet reached revenue generation and are in the early stages.
Similar to the scoring card method, one of the advantages of startup valuation with the Dave Berkus method is that various factors related to the startup business such as ideas, product prototypes and others are mentioned.
The Dave Berkus method is wholly based on experience and intuition, so this method is less accurate than other methods.
Risk factor summation method
The risk factor summation method first introduced by Ohio TechAngels Investment Group is a relative method for valuing startups. In this method, the startup is evaluated based on 11 risk factors so that the more risks the startup has, the lower its value will be. These risk factors are as follows:
- Managerial risk
- Economic risk
- Legal risk
- Market size risk
- Product prototype risk
- Investor exit risk
- Risk of intense competition
- Scalability risk
- Income model risk
- Risk of similar foreign models
In this way, according to the conditions of each startup, one can include other risks in the valuation. In this method, based on whether the risk factor has a negative or positive effect on the future performance of the startup, the investor applies a score between minus 2 to 2. For example, a startup can score two positive points in managerial risk, minus one point in investor exit risk, and zero points in income model risk.
Finally, one calculates the sum of points of all the factors. Then the final number is multiplied by $ 250,000. To calculate the pre-capital value of the startup, the figure obtained is added to the average pre-capital value of active startups at this stage.
The risk factor summation method is similar to scoring cards and the Dave Berkus method, as all are based on comparison and experience. For this reason, one can use this method to evaluate startups in the early stages and before generating revenue.
The main advantage of the risk factor summation method is that the business risks are important in determining the value of a startup. For this reason, this method must be one of the ways of valuing startups in the early stages.
Like the scoring card and Dave Berkus methods, the current process depends highly on the valuation team’s accuracy to determine the startup’s value.
Compared to other startup valuation methods, conformity valuation is more a strategy for investing in startups in the seed and early stages than a way to determine the value of a startup. In this method, the value of all startups is assumed to be the same. For receiving a fixed percentage of shares (for example, 10%), the investor spends a fixed budget. Therefore, startup owners can only accept or reject the offer of investors.
The conformity valuation method is appropriate for accelerators and angel investors to whom many startups turn to raise capital. Due to the costly and time-consuming process of reviewing and screening all startups, accelerators offer a consistent offer to all startups to reduce their costs, hoping that some existing startups will succeed randomly.
The main advantage of this method is for investors. They do not spend time or money evaluating startups.
The conformity valuation method does not provide the correct value to startups. That’s because the investor assumes all startups values to be the same.
In this method, the after-attracting value of the startup is equal to the exit value (Terminal Value), divided by the return expected by the investor. As you can see, the value of the startup in this method depends on the return that the investor expects . That is why this method is named the venture capital method.
The investor can determine the expected return based on the investment horizon, the economic conditions of each country, and the investor’s expectation. Given that the expected return is much higher than the risk-free interest rate, instead of using percentages, investors use a figure that indicates the multiplication of the initial capital after years. For example, an investor’s expected return on a 5-year horizon could be as high as 70, meaning that an investment of $ 10 million would increase to $ 700 million over five years.
The VC method is most suitable for middle and final stage startups on the verge of monetization or ones that have been profitable for a long time.
If similar examples of valued startups are available to estimate the final value and the investor’s expected return is also determined, The venture capital method is fast and straightforward compared to other startup valuation methods.
This method relies on startup revenue and future growth forecasts. Given the risks involved for startups, it is difficult and erroneous to predict their financial performance in the future. Also, determining investors’ expected return is a qualitative matter, and there is no quantitative way to calculate it.