In the recent decade, start-ups all around the world have seen unprecedented growth, with India taking a center stage in global markets because of high growth & reform expectations, demographic dividend, and large market, many Indian startups have come out, especially in the last couple of years, building scalable businesses and gathering millions of funds to reach a unicorn valuation. Last year, India registered unprecedented growth with 107+ unicorns who are improving our lives a little more every day.
And, if have ever wondered how business founders, investors, and seed fund managers come up with a valuation of early-stage companies, you are not alone. Raising funds is an inevitable part of any startup’s journey, and to establish a successful business, startups need to go through different rounds of raising funds such as pre-seed, seed, and series rounds.
Thus, the valuation of a start-up is an important factor for fundraising, as it helps the start-up to decide the amount of equity an entrepreneur has to give to an investor in exchange for requisite funds. In simple words, start-ups with higher valuations likely have to give a lesser amount of equity or shares to an investor in exchange for seed investment.
What is start-up valuation?
By definition, startup valuation is the process of measuring the worth of a company i.e. its valuation. In other words, start-up valuation is the value of a start-up business measured by taking into account factors such as any balance or imbalance between supply-demand of money, size of recent events, the willingness of investors to pay premiums to invest in the business, and the number of funds required by money.
However, business valuation is never the same for every business and could differ depending on the stage of business. For instance, in the case of a mature business, the business valuation could include valuing them as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA) or based on other industry-specific multiple. But, at the same time, the start-ups or businesses going for public listing may find it harder to assess their valuation when they are years away from sales or are with no revenue or profits and lesser certain futures.
Why is it important to assess the Start-up valuation correctly?
The term startup valuation is relative and is determined by several factors such as the business industry the start-up belongs to, the future of the industry, competition in the market, size of recent startup exits in the industry, etc. At times, the valuation of a start-up depends upon the willingness of an investor to pay a premium to get into a deal, while at other times, the desperation level of the entrepreneur looking for money might cause them to undervalue their startup to get the money needed. Hence, the founders must have adequate knowledge of the entire process of a startup company valuation.
For Instance, if you quote a high figure than the fair market value, it will be harder for your start-up to meet the set targets, leading to an even lower valuation in the next funding round. Additionally, it could hurt other investors toward your start-up making it even more difficult to convince your investors and raise funds. Whereas, if you value your start-up even lower than the fair market, you may end up giving up a larger portion of the startup equity to investors.
Pre-Money Valuation vs. Post-Money Valuation
Whenever you look for ways to calculate the net worth of your start-up, it becomes necessary to classify them into two basic categories – Pre Money valuation & Post-Money Valuation. But, how do they differ from each other? Well, the answer is both of them differ in terms of their timing. Both terms are considered crucial concerning start-up valuation.
While Pre-Money Valuation for a start-up business signifies how the business values itself and has to quote it before raising funds from external investors or under the latest round of investments. Having a higher pre-money valuation means higher chances of attracting better business funding.
On the other hand, Post money valuation is the valuation of the start-up after raising external funding and/or capital injections are added to its balance sheet. In other words, post-money valuation refers to the approximate market value offered to a start-up after a round of financing from venture capitalists or angel investors has been completed.
Factors Affecting Start-up Valuation
Though the valuation of your start-up is an intricate part, several other industry metrics are useful to correctly assess the value of a start-up. Thus, a higher valuation of any start-up is based on the start-up being able to possess the following attributes-
- Traction – One of the biggest factors of proving a valuation is providing the traction gained by your start-up including points such as how much duration you have been in the business, how faster it has grown in the past 12 months, the customer base it has or the immediate business plans, etc.
- Reputation – If the business founder/s holds a track record for coming up with the most innovative ideas or running successful businesses, or any product/services or processes, a such start-up is likely to gain a higher valuation.
- Profitability of the Business– It is obvious to understand the fact that investors like betting on the ability of any start-up to generate profits, early seed businesses that could offer a 20-30x return on their initial investments based on the risk to such early-stage capital.
- Supply and Demand –In the case where more founders are looking to raise external funding than the number of investors willing to invest, it could likely affect their start-up valuation. Also, in cases where the business founders are desperate, it may signify that they are looking to secure any investment & willingness to pay a premium.
- Distribution Channel – In case your start-up sells its product having a good distribution network could ensure a higher valuation of the start-up.
- Industry Trends-In cases where the start-up belongs to any specific industry which is trending right now (i.e. Technology or Internet, etc.), there are higher chances that your start-up will have a higher valuation if it belongs to the right industry. If your start-up belongs to an industry that has recently shown poor performance or maybe died off, it could affect the valuation of your start-up.
- Lower Margins – Start-ups engaged in the business industries with lower business margins may make it less desirable to invest in the business.
- Weak Management – If the management team of a startup holds no experience in the relevant industry or key business positions are missing, it could affect the valuation of your start-up.
What are the common methods used to assess the valuation of a start-up?
Here are some popular methods to calculate the valuation of a start-up-
Berkus Approach
Evaluating the valuation of an early-stage business could be a challenging task. While some founders are hopeful for the highest valuation of their business based on optimistic future revenues, others may prefer lower valuation methods based on current revenues. Thus, the final valuation will depend on how founders and investors agree on a common valuation.
Thus, the Berkus Approach to valuing start-ups is the method in which an estimated value of the start-up is determined by taking into consideration five key factors namely its basic value, technology, strategic associations in its core market, execution, production, and consequent sales. under this method, a detailed evaluation of a start-up business is carried out by assessing the value of all these key factors in quantitative measures added up to the total value of the enterprise to reach the final value of the start-up.
Since this method is more relevant for early-stage start-ups, this method is also referred to as Stage Development Method or the Development Stage Valuation Approach for start-ups.
Cost-to-Duplicate Approach
As the name suggests, the Cost-to-Duplicate Approach is based upon the idea that how much a business would cost to build another similar company from the scratch, as no investor would pay more than the cost of creating its duplicate. It involves taking into consideration all costs and expenses expended by the start-up, the development of its products, and the value of its physical assets to determine their fair market value. For instance, in the case of a tech start-up business, its net worth could be figured out as the total cost of programming time that has gone into designing its software or even the cost of development of product prototypes, obtaining patent rights, etc.
Thus, the cost-to-duplicate method is often considered the starting point to finding out the valuation of a start-up as it is based on verifiable, historic expense records. However, the two major drawbacks to the Cost-to-Duplicate Approach-
- Failure to take into consideration the future potential of the company by running projection statements of its future sales and growth, and
- Failure to undertake intangible assets such as brand value, patents, designs, goodwill, etc. which are a crucial part of the valuation of a start-up at each stage.
Market Multiple Approach
The Market Multiple Approach is one of the most popular startup valuation methods among venture capitalists, as it gives them an idea about the willingness of the market to pay for a company. This method values a start-up by taking into consideration the recent acquisitions of similar start-ups or businesses in the market, followed by which a base multiple is determined based on the value of the recent acquisitions. For instance, the case of a software tech start-up in its early stage as compared to other later stage businesses would fetch a lower multiple than five given the higher risk being taken by investors.
To value a start-up in its infancy stages, it is necessary to undertake extensive forecasts to find out the number of earnings or sales that will take place once it reaches its mature stages of operation. Business investors will often offer funds to a start-up if they believe in the business model or product being offered by the business, even before it starts to generate earnings. While certain established corporations are valued based on their earnings, the value of startups often has to be determined based on their revenue earnings.
Thus, the market multiple approaches arguably offer value estimates which come closest to the value that investors are willing to pay. However, one major drawback of this method is the inability to find a comparable market transaction, because no two start-ups could be the same in every business aspect, especially in the startup market. Deal terms with unlisted & early-stage start-ups are usually kept under wraps, those that probably represent the closest comparisons.
Additionally, early-stage start-ups often keep the deal terms under wraps usually those who probably represent the closest comparisons.
Discounted Cash Flow (DCF)
The Discounted Cash Flow (DCF) Method is a method of start-up valuation that focuses on the projections of the future cash movements of a start-up and on the such value a certain percentage of discount is applied to determine the worth of the projected cash flow worth of a start-up. As the amount of risk in case of an early stage start-up is higher, there is a high risk associated with investment and thus, a heavy discount rate is generally applied.
Therefore, for start-ups that have yet to start generating business earnings, a large amount of value rests on their future potential, thus, in this method forecasts are made into cash flow to be generated in near future including an expected rate of investment return, the worthiness of the cash flow in the business is calculated.
Despite its effectiveness, one major drawback in the Discounted Cash Flow is that the quality of the DCF depends on the ability of the analyst to make the right forecasts about market conditions and make the right assumptions about long-term growth rates. Again, the DCF approach is sensitive to the expected rate of return applied for discounting cash flows. Thus, the method should be cautiously applied.
Risk Factor Summation Approach
The Risk Factor Summation Approach or RFS method is a rough pre-money valuation method relevant for early-stage start-ups. In this method, all the risks connected to a start-up that could potentially affect the return on investment made by an investor, are to be taken into consideration. The base value has to be adjusted to 12 standard risk factors by comparing one start-up to the other start-ups & assess whether you have a higher or lower risk.
Some of the business risks which are to be taken into account include management, political, manufacturing risk, market competition, investment, and capital accumulation, technological risk, and legal environment risk. Once all these risks are considered & implementing the “risk factor summation” to the initial estimated value of the startup, the final value of the startup shall be determined.
Valuation By Stage Approach
Lastly, the valuation by stage method is an approach usually implemented by angel investors and venture capital firms to roughly decide the range of the value of the start-up. The rules for determining valuation are typically set out by investors depending upon the commercial development of the start-up and the progress made by the company along the development pathway. Hence, the lower the risk, the higher will be the valuation of the company.
However, start-ups having nothing more than a business plan will get the lowest valuation from all the investors. But, as the start-up continues to grow while succeeding in the development of milestones investors will be willing to assign a higher value.
Private Equity Firms will utilize this approach, whereby they offer additional funding when the firm reaches a certain milestone. For example, in the initial round funds may be offered to run the day-to-day business operations such as paying wages for employees for product development. In the next stage, funds may be provided for mass production and entering markets, and so on.
Common mistakes to Avoid while evaluating a startup
It is very easy for startup owners to get carried away and value their start-ups at the highest valuation possible. Thus, it is necessary to make a thorough research to get an actual factual basis while assessing the valuation of your start-up. Many business founders tend to overestimate their business value, which puts off the investors. If required, it is advisable to consult accountants and lawyers to help in valuing your startup.
Bottom Line
It’s a known fact that the process of determining start-up valuation is not easy, especially in its infancy stages where its success or failure remains unclear. The different approaches to start-up valuation may offer different distinctive results at various stages of growth, and it is important to know when one method is more appropriate to use over another.
Each method has its pros and cons, and investors may choose to consider one method over the other depending on the stage of the business. Whatever approach is considered, it is important to find it as accurately as possible with the numbers. It will ensure that your start-up could make the most out of its external funding opportunities while holding as much equity as possible in your control as the business grows.