Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Understanding startup valuation
Determining the value of a startup before it has made significant revenue can be a difficult process. In truth, many factors must be considered. The demand for a product in the market is perhaps the most obvious, but it is also important to evaluate the management team and any associated risks.
The entrepreneurs behind the startup will prefer to see a high valuation, while startup investors will prefer a lower value to maximize their return on investment. In most cases, the exact value of the company is somewhere in the middle.
In the next section, we’ll take a look at some of the factors used to value a startup in more detail.
Factors that influence startup valuation
For businesses without revenue, it is worthwhile to consider the following:
- Traction – one of the more accurate predictors of future value is proof of concept. Does the startup have customers? Can it attract high-value customers for a relatively low cost of acquisition? Is there an appreciable growth rate? These factors, to some extent, are proof that the business is scalable.
- Team success – a brilliant idea can only be realized by a brilliant team. Proven and relevant experience is always beneficial, but the team should ideally have a complementary mix of skills and be committed to getting the company off the ground.
- Supply and demand – if the industry a startup hopes to impact is characterized by many competitors and relatively few investors, its valuation may be affected. On the other hand, a startup with a revolutionary idea or patented technology may cause a bidding war among investors and increase its value.
- Prototypes and minimum viable products (MVPs) – the presence of a prototype or MVP shows investors the startup has the drive to realize its vision. A minimum viable product with early adopters, for example, can attract angel finance in the vicinity of $500,000 to $1.5 million.
Startup valuation techniques
There are many startup valuation techniques in use today. Below we will take a look at some of the more popular:
Named after venture capitalist Dave Berkus, the Berkus Method attributes a $500,000 valuation to a total of five success metrics. These metrics are a sound idea, the presence of a prototype, quality management, strategic relationships, and product rollout or sales. In theory, the most a startup is worth under this model is $2.5 million.
This method evaluates the costs and expenses associated with the startup and product development. The value of physical assets is calculated which then determines how much it would cost to create an identical business from scratch. For example, a tech startup may be valued on the cost of filing a patent, creating a prototype, and research and development. However, this method does not consider intangible assets such as brand value and is not forward-looking.
Venture capital (VC) method
This method was developed by Harvard Business School Professor Bill Sahlman and, as the name suggests, is used by venture capital firms. The process starts with calculating the terminal value – or the expected value of a startup after the VC firm has invested. From that point, it is important to work backward with the expected ROI and investment amount to calculate the pre-money valuation. The startup will also need to know its industry-specific price-to-earnings (P/E) ratio.
- Startup valuation describes a suite of methods used to value companies with little or no revenue.
- To value a startup company, it is worthwhile to consider traction, team success, market supply and demand, and the presence of a prototype or minimum viable product.
- Three common startup valuation methods include the Berkus Method, cost-to-duplicate method, and venture capital method.
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