startup-valuation

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 Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
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.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

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

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 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 Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with 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.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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

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