Valuing a startup is one of the most challenging tasks often required by financial analysts. In this article, we will discuss how to value a startup as well as some of the more popular valuation methods. Startups, in the most general sense, are new business ventures created by an entrepreneur. The startups 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 Berkus approach, cost-to-duplicate approach, future valuation method, the market multiple approach, the risk factor summation approach, and discounted cash flow (DCF) method.
The Berkus approach, created by American venture capitalist and angel investor Dave Berkus, looks at valuing a startup based on a detailed assessment of five key success factors: basic value, technology, execution, strategic relationships in the core market, and production and consequent sales.
A detailed assessment is carried out evaluating how much monetary value is assigned to the five key success factors. The startup valuation is the summation of those monetary values. This approach normally allocates up to $500,000 per success factor for a theoretical maximum pre-money valuation of $2.5 million. 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. The cost-to-duplicate approach comes with the following drawbacks:
Not taking into consideration the company’s future potential by projecting financial 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 to 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, approximately five to ten years. Future sales growth and cost projections are made over the forecast period. A multiple is then applied to the appropriate metric in order to value the startup.
Market Multiple Approach
A market multiple is calculated using recent acquisitions or transactions that are similar in nature to the startup. The startup is then valued using the calculated 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 either deducted or added to the initial value based on the effect of the risk.
After taking into consideration all risks and implementing the “risk factor summation” to the initial estimated value of the startup, the final value of the startup is determined. 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 Method
The discounted cash flow (DCF) method focuses on projecting the startup’s future free cash flow. A rate of return on investment, called the discount rate, is then estimated. Since startups are new companies and there is a high risk associated with investing in them, a high discount rate is generally applied. The future free cash flows are then discounted back to present value.