Whether you are an investor, an entrepreneur, or just curious about the startup ecosystem, understanding the nuances of startup valuation is essential.
If you want to know how to value a startup, this article will help steer your valuations in the right direction and offer some useful insights.
Understanding key metrics
Valuing a startup starts with understanding the key metrics that drive the business. These metrics can vary depending on the startup. For tech startups that are pre-revenue, venture capitalists (VCs) may look at metrics such as monthly active users, user growth rates and churn rates to help determine the value of a startup as an asset.
Alongside these quantitative metrics, VCs and professional investors may also look at qualitative metrics, such as the strength and experience of a startup’s team, the competitive landscape, and any proprietary technology or intellectual property the startup holds.
Starting out with little to no revenue
It is not uncommon for startups, especially in their early stages, to have little to no revenue. In such cases, valuing these businesses is challenging. A common approach is to use the venture capital valuation method. This typically focuses on the projected returns for the investor, typically at an exit event such as a future funding round, acquisition, or even an IPO.
Another approach is to use the scorecard method. This is when you attempt to compare a startup to other similar businesses in the same stage of development and industry. You can make adjustments for factors such as the strength of the management team, the size of the market, and product novelty, to ensure you are fairly calculating the startup’s value.
Link between equity and valuation
Equity plays a crucial role in startup valuation. When a startup raises funding, it is often issuing equity in exchange for investment. The value of the equity directly impacts the valuation. The percentage of the startup that the investor receives for their investment and the post-investment value of the startup determine the pre-investment value, or the pre-money valuation.
Common mistakes when valuing a startup
One of the biggest mistakes when valuing a startup is overlooking the importance of the founding team. The team's experience, skills and track record can often determine the trajectory of a startup.
Another common error is overemphasising current financial performance. The future growth potential of startups often matters more than current profitability or revenue.
If you are overly reliant on any single valuation method or metric, this can lead to skewed results. When valuing a startup, you should aim to use a blend of valuation methods while acknowledging the assumptions and limitations of each method. This is crucial to giving fair and grounded valuations.
Methods to calculate valuation of a startup
Here are just a few valuation methods that we should mention:
Cost-to-duplicate
This method calculates the cost to recreate the startup's product or service from scratch. As cost-to-duplicate does not account for future profits or intangible assets such as the brand value of a startup, it is generally considered a conservative approach to valuation.
Market multiple
Attaching a market multiple to a startup is designed to peg the business at a similar selling price to other companies in the market. Even though it can provide you with a real-world benchmark, it assumes that the startup you are valuing is as mature and profitable as the other companies.
Discounted cash flow (DCF)
The discounted cash flow (DCF) formula involves estimating future cash flows and discounting them back to the present value. As early-stage startups often have irregular and unpredictable cash flows, it is difficult to use this formula to get a fair valuation.
Summary
As startup valuations often involve a mix of quantitative metrics and qualitative factors, it is both an art and a science. If you want to reach a valuation that is grounded and rooted in reality, you must take a broad range of factors into consideration. This will ensure you land on a number that accurately reflects where the startup is at on a number of different fronts.
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The opinions on this page are for general information purposes only and do not constitute legal advice on which you should rely.
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