With this piece, we understand how is a startup valued. Ever come across those fancy bn dollar valuations popping up your screen now and then? With this piece we understand popular startup valuation methods.
Have you ever come across those fancy bn dollar valuations popping up your screen every now and then? Would you be surprised if we tell you that some of these startups have not even started making profits or even revenue? In fact, they’re losing money. Does the curiosity of “how these start-ups are valued, ever pops up your mind?
Well, we’re here to do that for you. With this piece, we’ll cover how start-ups are valued. We’ll walk through a few steps to understand how investors put a price tag on them even before they become profitable. In most cases.
Why valuation is important?
Start-ups in the early stages have either no revenue or no profit, which makes valuing a start-up particularly challenging. But what does it mean to value a start-up, you may wonder? To tell you, it is the process of arriving at the accurate value of a start-up so that investors get the right percentage of stake in it.
Take, for example, a start-up is valued at $100,000 and a VC (Venture Capital) firm is willing to invest $20,000 in it. The valuation of a start-up before it receives its first or an additional round of funding is known as Pre-money Valuation. So, in this example, $100,000 is the pre-money valuation of the start-up. After the start-up receives its first or additional round of funding, the valuation we get is called the Post-money Valuation.
Post-money Valuation = Pre-money Valuation + Investment made
After the investment is made, the start-up will be valued at $120,000, therefore, this is its post-money valuation.
The VC’s stake in it, after investment, will be = (20,000/120,000)*100
Upon calculating, the stake comes out to be 16.67%.
What happens if you value a startup incorrectly? Well, chances are, you lose money.
Now, let’s see what can happen if the valuation of the start-up goes wrong. Assume that the VC firm overvalues the start-up at $110,000 and then invests $20,000 in it. This investment pegs the post-money valuation of the start-up at $130,000.
The VC’s stake in it, in this case will be = (20,000/130,000)*100
This time, the stake comes out to be 15.38%, which is about 1.28% lower than when the start-up is accurately valued. While the difference may seem small, when the start-up goes for an IPO, it will receive millions or even billions in capital. So, during an exit through IPO for the VC, a difference of even 1% is sizeable. Therefore, it becomes all the more important to value a start-up accurately.
However, note that arriving at the right value for a start-up is not easy, as there is little past data available, it’s being more an art than science. Which makes the process even tricky. The art part usually includes understanding the capabilities of the management, soundness of the idea, industry potential and so on. Since the art of it is beyond the scope of this piece, we’ll focus on the science part only. The following methods, among many others, are used for valuing start-ups:
How is a startup valued? Startup valuation methods:
Venture Capital Method:
This method is used to arrive at the pre-money valuation of a start-up that hasn’t started earning revenues yet. The aim here is to derive a potential exit value. The potential exit value or the terminal value is a start-up’s estimated valuation at a certain point in the future, say, after 10 years. Let’s assume that the terminal value of the start-up is $30 million. And, let’s assume that the investor is hoping for a 10x return. This return will be expected after the investment has been made, i.e. on the post-money valuation.
Post-money Valuation = Terminal Value/Expected Return
Therefore, the post-money valuation will be $3 million.
Now, let’s assume that the start-up requires its first or additional funding of $100,000 (or $0.1million) to generate positive cash flows. Once, it starts generating positive cash flows, it can fund the operating costs with those cash flows only. It will seek this amount from an investor. From the post-money valuation we calculated, and the investment amount we assumed, we can easily calculate the pre-money valuation with the formula given earlier, which comes out to be $2.9 million. This is the valuation that an investor will be looking at.
That is: Post-money Valuation = Pre-money Valuation + Investment made
Therefore, $3mn = Pre-money Valuation + $0.1mn
Pre-money Valuation or the actual valuation before investment = $2.9million
This method is also used for early-stage start-ups that haven’t started earning revenues. In this method, a start-up is valued on the basis of five key aspects. Each aspect is given a certain amount of money ranging from zero to $500,000 or ($0.5 million) depending on the degree in which each aspect is present or developed in the start-up.
|Quality management team||Zero to $0.5 million|
|Sound Idea||Zero to $0.5 million|
|Working prototype||Zero to $0.5 million|
|Quality board of directors||Zero to $0.5 million|
|Product rollout or sales||Zero to $0.5 million|
So, if a start-up has an excellent quality management team, it will be given $0.5 million for the part and if it has an average working prototype, it will be given $0.25 million. Similarly, for each aspect the start-up receives a certain amount, the total of these amounts is its pre-money valuation. This technique is useful when financial forecasts are not feasible.
Market Multiple or Comparable Pricing Method:
This method is based on the valuation of comparable start-ups in the market. The market multiple approach values a start-up against recent acquisition or transactions of similar companies in the market. Take, for example, a similar short-video making app to the one you are looking to value, was acquired at $50 million and it had 100,000 monthly active users (MAU). Therefore, the value of the app per MAU will be $500. This value can be used as a baseline for valuing the start-up. The investor may consider a lower or higher per MAU value than the baseline depending upon the stage of the start-up, its capabilities, industry potential and several other characteristics.
While this method is comparatively easy, finding comparable market transactions is a difficult task given that the details of such deals are often undisclosed and little information about a start-up is available as it is unlisted.
These are only a few methods among others, such as Discounted Cash Flow (DCF) Valuation, Cost-to-Duplicate and The Risk-Factor Summation methods that are used to value start-ups.
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