What are Startup Valuation Methods?
Several startup valuation methods are available for use by financial analysts. Below, we will discuss some popular methods used for valuing startups. Startups, in the most general sense, are new business ventures started up by an entrepreneur. They usually tend to focus on developing unique ideas or technologies and introducing them into the market in the form of a new product or service.
- Startups, in the most general sense, are new business ventures started by an entrepreneur.
- The various methods through which the value of a startup is determined include the (1) Berkus Approach, (2) Cost-To-Duplicate Approach, (3) Future Valuation Method, (4) the Market Multiple Approach, (5) the Risk Factor Summation Method, and (6) Discounted Cash Flow (DCF) Method.
The Berkus Approach, created by American venture capitalist and angel investor Dave Berkus, looks at valuing a start-up enterprise based on a detailed assessment of five key success factors: (1) Basic value, (2) Technology, (3) Execution, (4) Strategic relationships in its core market, and (5) Production and consequent sales.
A detailed assessment is carried out evaluating how much value the five key success factors in quantitative measure add up to the total value of the enterprise. Based on these numbers, the startup is valued. The Berkus Approach may sometimes also be referred to as “the Stage Development Method or the Development Stage Valuation Approach.”
The Cost-to-Duplicate Approach involves taking into account all costs and expenses associated with the startup and the development of its product, including the purchase of its physical assets. All such expenses are taken into account in order to determine the startup’s fair market value based on all the expenses. The cost-to-duplicate approach comes with the following drawbacks:
- Not taking into consideration the company’s future potential by running projection statements of its future sales and growth.
- Not taking into consideration its intangible assets along with its physical assets. The argument here is that even at a startup stage, the company’s intangibles may have a lot to offer for its valuation, i.e., brand value, goodwill, patent rights (if any), and so on.
Future Valuation Multiple Approach
The Future Valuation Multiple Approach solely focuses on estimating the return on investment that the investors can expect in the near future, say five to ten years. Several projections are carried out for the said purpose, including sales projections over five years, growth projections, cost and expenditure projections, etc., and the startup is valued based on these future projections.
Market Multiple Approach
The Market Multiple Approach is one of the most popular startup valuation methods. The market multiple method works like most multiples do. Recent acquisitions on the market of a similar nature to the startup in question are taken into consideration, and a base multiple is determined based on the value of the recent acquisitions. The startup is then valued using the base market multiple.
Risk Factor Summation Approach
The Risk Factor Summation Approach values a startup by taking into quantitative consideration all risks associated with the business that can affect the return on investment. Under the risk factor summation method, an estimated initial value is calculated for the startup using any of the other methods discussed in this article. To this initial value, the effect, whether positive or negative, of different types of business risks are taken into account, and an estimate is deducted or added to the initial value based on the effect of the risk.
After taking into consideration all kinds of risk and implementing the “risk factor summation” to the initial estimated value of the startup, the final value of the startup is determined. Some types of business risks that are taken into account are management risk, political risk, manufacturing risk, market competition risk, investment and capital accumulation risk, technological risk, and legal environment risk.
Discounted Cash Flow Approach
The Discounted Cash Flow (DCF) Method focuses on projecting the startup’s future cash flow movements. A rate of return on investment, called the “discount rate,” is then estimated based on which it is determined how much the projected cash flow is worth. Since startups are just starting out and there is a high risk associated with investing in them, a high discount rate is generally applied.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: