How Much is Your Startup Worth? Five Ways to Find Out | DataDrivenInvestor
A startup worth evaluation reminds me of a coin toss. With no operational value, real income, or сlear-eyed market feedback, tangible metrics cannot provide a reliable number. Almost 40% of startups fail hemorrhaging cash and are unable to raise new capital, widely due to an initial lack of judgment. I’ve figured that you can make a better prediction and minimize losses by leaving “a come what may” approach aside.
How to Value a Startup? Five Market-Proven Strategies
Examples of overvalued bubbles (think WeWork) and undervalued stars (think Calendly) made me wonder whether the rule of thumb prevails when assessing a startup. Are we doomed to keep gambling? I believe not. However, it takes effort and experience to leave this roulette to rookies and join a higher, more cold-blooded league.
Working with startups for XX years by now, I’ve binged their “from zero to hero” and “fallen unicorn” stories like others binge The Crown or a Squid Game. Squeezing dry this cumulative experience, I hand-picked four approaches to finding out your startup’s worth.
Dave Berkus Method
In a nutshell: Assess success factors from 1 to 5, sum up, multiply by $100.000.
Pros: Fast, straightforward. Cons: oversimplified, somewhat unbalanced.
It is the closest to the “rule of thumb” you will get choosing among startup valuation methods. Nevertheless, it’s the most straightforward way to calculate the “baseline.”
Assess your startup by the following criteria, ranking each from 1 to 5: idea uniqueness, prototype (technology), management team expertise, strategic relationships, existing product, and sales. Imagine that each point you grant is worth $100.000. Here is the picture you get:
Idea — 3 points — $300 000
Prototype (technology) — 4 points — $400 000
Management — 2 points — $200 000
Strategic relationships — 2 points -$200 000
Product and sales — 3 points — $100 000
Everything revolves around uniqueness and risk. The first item evaluates your uniqueness, while other characteristics evaluate your business’s ability to mitigate potential risks.
Be honest with yourself, and don’t get discouraged if some numbers are low. Berkus considered any estimation over $2 million unrealistic. Now, ask yourself whether your startup has the potential to reach the $20 million threshold within four years. If the answer is yes, it’s time to look for an investor.
With a tech rout 2022 that can potentially be followed by a 2023 recession, venture capital firms are looking for cheaper early-stage start-ups. If you are looking for some fast-track deals, whip up some numbers using Dave Berkus valuation method and start pitching.
Risk-Factor Summation Method
In a nutshell: Initial startup value adjusted according to 12 risk factors.
Pros: In-depth risk assessment Cons: initial cost is often too approximate
This method is often seen as the Berkus method’s derivative. Still, you are not obliged to define a startup’s initial value using his approach. The key to minimizing potential problems is understanding them and their value. Here are the risks you need to consider:
- Management (system, approach, executive team experience, etc.)
- Stage of business (affects the prognosticability)
- Political risks (changes in legislation, upcoming elections)
- Production risks (do you have an established line already?)
- Marketing and sales risks (market vision, well-knit supply lines)
- Funding risks (how fast can you find extra capital for your business?)
- Competition risk (are there competing products and how strong are they?)
- Technology risks (level of tech experts, access to advanced technology)
- Litigation risks (partners’ rights, patenting, etc.)
- International risks (shipping, analogues, international patent laws)
- Reputational risks (non-eco-friendly product, stakeholders involved in scandals)
- Lucrative exit potential
Based on how strongly each risk can affect your startup, mark it in a range from -2 to 2. Values spread as follows:
-2 = -$500 000
-1 = -$250 000
0 = 0
+1 = +$250 000
+2 = +$500 000
With even unicorn-level startups such as Vedantu or Meesho going from feast to famine these days, I can’t help but wonder, whether risk assessment is done at any level.
I advise assessing the startup via this method even to those who already have a strong investor. Knowing which risks can take you down is enlightening. A small tip! If thinking about one of the risk points urges you to stop this exercise, it’s a red flag for the toughest challenge of all.
Comparison to Other Startups
In a nutshell: Find the closest lookalikes and get to know how much money they got.
Pros: Broadens your market vision. Cons: May be too approximate and discouraging.
Comparing your business to others in your niche to define a startup’s potential value belongs to market-oriented, classic valuation methods. It implies that your idea isn’t 100% unique, but there are hardly many one-of-a-kind ideas, and you need to assess other fish in a tank.
Research your niche and the availability of similar projects in other regions. Check what kinds of investments those businesses received over the course of their existence.
Market-oriented methods of startup valuation are of top importance when preparing for equity crowdfunding. There is a research work dedicated to strategy evaluation of startups at crowdfunding platforms you may want to check out. Emphasizing a low level of economic understanding among small investors, it proves you need to have market-fit offer ahead of appealing numbers.
Discounted Cash Flow Method (DCF)
In a nutshell: An estimate based on the sum of all future cash flows.
Pros: Realistic, based on investor’s interest. Cons: challenging for newbies
The overall startup value can be assessed as the sum of all future cash flows in the coming years. I use DCF evaluation to make a precise estimation of this value based on the startup owner’s or investor’s intent.
First, estimate future cash flows (CF1, CF2, CF3… depending on a number of years). Discount a cash flow using the following formula:
DCF(k)=CF(k)/(1+r)^k (where “r” is the discount rate)
To define a present value, sum up everything including the Terminal Value:
Options for Terminal Value estimation:
TV Option #1 — you expect your business to increase its value continuously and generate certain (yet unknown) cash flows in N years.
TV1 = CFn + 1/(r-g);
where “g” is the expected growth rate
TV Option #2 — you plan to exit this startup in N years. Then you need to discount the future value.
TV2 = initial value/(1 + r) ^ n
When aspiring for investments bigger than $20–200 crowdfunding bids, you need to please VC firms with cash flow and terminal value analysis. From my experience of working with startups in QArea, startup owners are full of vision but need help with getting numbers straight and alluring. If you are drafting the first estimates, use simpler methods. If you are looking for big-league investors — let experts handle more complex valuations.
The market sees an awing number of Zombie-startups. Zombies barely survive at a minimum threshold, with no ability to grow. In many cases, it is the result of neglecting to estimate the Terminal Value, and make a well-reasoned prediction. If you don’t want to follow the fate of, for example, more than 90% of Digital Health startups, please, don’t neglect this valuation method due to its complexity.
Venture Capitalist Method
In a nutshell: Estimation based on ROI expected by investors
Pros: Highly appreciated by VC firms. Cons: Requires more complex estimations
The key to all VC investments is the price-to-earning ratio (P/E). This ratio compares the price of a stock in your company to the potential earnings of your business.
This valuation method often requires a full internal audit of your business (a step that any VC firm will insist on before making an investment). Here is how the estimation goes:
Post-money Valuation = Terminal Value ÷ Anticipated ROI
Before supporting your endeavor, a businessman or a VC firm will assess the expected return on investment and a potential sum your startup can be sold in 8–10 years. Combining these elements determines a possible maximum amount of the investment after adjusting for future capital fragmentation.
What Method is Right for Your Startup?
You can use each valuation method at any stage of your startup development. However, my experience in the market allows me to recommend you the following strategy.
The Berkus method and Market comparison method — are applicable at the earliest stages, while you haven’t even written a single line of code.
Risk factor summation method (RFS) — once the initial startup value is assessed, to minimize the risks or provide the investor with a clear, balanced picture.
Venture Capital method — most suitable for projects in the early and mature stages of development for attracting first and “boosting” investors.
Discounted cash flow method (DCF) — once a startup is launched and running, tangible metrics are used to assess its real value, and you want to make a report for investors and/or attract more capital for development.
Roll up your sleeves, draw up the balance sheet, and start crunching numbers for adequate startup valuation. Good luck!
Originally published at https://www.datadriveninvestor.com on August 8, 2022.