What Is Startup Valuation? Startup Valuation In A Nutshell

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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:

Berkus Method

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.

Cost-to-duplicate method

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.

Key takeaways:

  • 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.

Connected Business Frameworks

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flows

The cash flow statement is the third main financial statement, together with an income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Finanial Structure Modeling

In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.

Tech Modeling

A tech business model is made of four main components: value model (value propositions, missionvision), technological model (R&D management), distribution model (sales and marketing organizational structure), and financial model (revenue modeling, cost structure, profitability and cash generation/management). Those elements coming together can serve as the basis to build a solid tech business model.

Read Next: Income StatementBalance SheetCash Flow Statement, Financial StructureWACCCAPM.

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