How to Calculate Valuation of a Startup and What Are Its Different Types
How Startup Valuation Works And Why Is It Important?
Entrepreneurs care about valuation because it decides how much of their firm they must give away in exchange for money. Let's imagine you're searching for a $100, 000 startup investment in exchange for a 10% stake in your company. Your pre-money value will be one million dollars. This does not, however, necessarily imply that your company is now worth $1 million. You probably wouldn't be able to sell it for that much. In the early phases of a business, valuation is primarily concerned with the potential for growth rather than the current value.
Keep on reading to find out more about how startup valuation works.
How to Calculate The Valuation of a Startup Using Several Effective Methods
If you have revenue and customers, determining and increasing a company's worth will almost certainly begin with some model, usually a multiple of your business indicators. There are resources out there to assist you to work out a more accurate answer to the question of how to calculate the valuation of a startup.
By focusing on risk considerations rather than financial expectations, the Berkus Approach gives entrepreneurs and early-stage investors a clear framework for valuing a pre-revenue firm. Founders and early-stage investors will benefit from this strategy (angels, early-stage venture capital, and crowdfunding backers). The model's simplicity, however, does not negate the requirement for thorough due diligence on the firm.
• The Berkus Approach of Valuation is an early-stage valuation method designed to establish a starting point without relying on the founder's financial expectations. The Berkus Method examines five critical aspects of a business and assigns a value to each of them ranging from zero to $500,000. These are the areas in question:
• Sound Business Idea: For example, $0 – $500,000: The company has a novel business concept.
• Team in charge of quality assurance: For example, in the range of $500,000 to $1,000,000, the company has put together an exceptional management team.
• $1,000,000 – $1,500,000 for a prototype: The company has a good product or prototype that appeals to buyers.
• Relationships that are strategic: For example, a company with $1,500,000 to $2,000,000 in revenue has strong strategic relationships, partners, or a growing customer base.
• Is it better to launch a product or sell it? $2,000,000 – $2,500,000, for example. There are signs of sales growth and a route to profitability for the company.
The startup's pre-money valuation is calculated by adding all of the designated values. The Primary Berkus Approach featured five sections with a $500k maximum, resulting in a theoretical maximum pre-money valuation of $2.5 million. However, the drawback of the approach is the valuation limit which imposes a restriction of the usability of the approach.
The Cost-to-Duplicate Approach is the method of appraisal that necessitates research. It works by estimating the cost of duplicating the company as it is at the moment of appraisal as nearly as possible.
This method necessitates substantial research, but it is one of the most realistic methods for valuing a business because it considers everything from the initial concept through labor and relationship-building.
The disadvantage of the Cost-to-Duplicate Approach for startups in the early phases of development is that your firm is likely to have a low value unless you have a structure or concept that is extremely difficult to copy. A firm with a unique idea and product, on the other hand, could be worth a lot of money even in its early stages.
Future Valuation Multiple Approach
The Future Valuation Multiple Approach assesses long-term Return on Investment (ROI) over a period of five to ten years.
The startup's worth is determined by estimates like cost and spending projections, sales and growth, and other similar data. Moving forward with the ROI, the risk factor summation technique considers all business risks that could have a negative impact on the ROI.
Management, political, obsolete technology, competition, manufacturing, investment, legal risk, and other company risks are all taken into account. Once a startup's first valuation has been determined using any of the valuation approaches, the impact of business risks is either added to or deducted from the initial value, depending on whether the risk is positive or negative.
However, one disadvantage of the Future Valuation Multiple Approach is that it does not account for future dilution.
Market Multiple Approach
The multiples analysis is a valuation method that uses many financial measures from comparable companies to determine the worth of a target company. As a result, the premise is that particular financial ratios' relative value can be utilized to rank or evaluate a company within a similar group.
Market Multiple Approach, despite being one of the oldest methods of valuation, is still utilized. It is now being used in valuations alongside discounted cash flow analysis and other market-based methodologies.
The ease with which multiples can be used in valuation is both a benefit and a drawback. It's a drawback since it reduces complicated information to a single value or a series of values. Other elements that affect a company's intrinsic worth, such as growth or decline, are effectively ignored. This simplicity, on the other hand, allows a financial analyst to perform simple calculations to determine a company's worth.
Using various analyses, on the other hand, can make it difficult to compare firms or assets. This is because organizations may have various accounting policies, even if their business operations appear to be the same. As a result, multiples are susceptible to misinterpretation, and comparisons are less conclusive. Different accounting policies necessitate adjustments.
The future is similarly ignored in Market Multiple Approach because it is static. It solely evaluates the company's position over a specific time and ignores the company's expansion in its business activities. However, certain multiples that look at "leading" ratios can be used to compensate for this.
Risk Factor Summation Approach
For the valuation of your firm, the Risk Factor Summation Approach uses a base value of a comparable startup. This baseline value is then tweaked to account for 12 common risk variables. This implies you compare your startup to others to see if you're at a higher or lower risk.
• You begin by calculating an average firm valuation based on similar businesses in your location and region. Allow plenty of time for this phase. It can take a long time to locate relevant data for a comparable organization.
• Then, on a scale of very low to very high, you compare the various risk variables for your own startup.
• Lower risks improve your company's valuation, whilst bigger risks diminish it.
• You might try to focus on your risks and establish plans to cover or lessen them to increase your valuation.
In addition, many investors utilize multiple valuation methods to determine a startup's valuation range.
Discounted Cash Flow Approach
Discounted Cash Flow Approach (DCF) is a method for calculating the net present value of future cash flows. This method can be used to calculate the worth of an investment. When using the DCF approach, a discount rate is applied to each periodic cash flow produced from an entity's cost of capital. When you multiply this discount by each future cash flow, you get a total that equals the present value of all future cash flows.
Calculating the discounted cash flows for a variety of investment options allows one to choose the option that produces the highest discounted cash flows. This notion can be used to determine the worth of a potential acquisition, annuity investment, or fixed asset purchase.
The premise that cash obtained today is more valuable than cash received in the future is at the heart of the Discounted Cash Flow Approach. The reason for this is that someone who commits to being paid later forfeits the chance to invest that money right now. The only way to get someone to agree to delayed payment is to pay them for it, which is referred to as interest revenue.
The fundamental disadvantage of discounted cash flow is that it necessitates the prediction of future cash flows. It is extremely difficult to predict cashflows in untapped markets or markets that would be disrupted by new technologies. The risk to generate predicted cashflows increases with the length of the forecasting horizon.