By Christine Chu
Valuing your startup is still an important step in raising capital. Let’s go over four different approaches to valuing your startup.
A savvy investor wouldn’t put in more than it would cost to duplicate your startup. Thus, by looking at physical assets and calculating the cost to duplicate your startup from scratch, you’ll be able to determine a fair market valuation.
Using the cost-to-duplicate approach to valuing your software startup, for example, you could look at the cost of time gone into designing and programming the software. This might include costs to date of research and development, patent protection, and prototype development. As these calculations are fairly straightforward and objective, this approach is a good starting point to valuing your startup.
However, using the cost-to-duplicate method should really just be a starting point. A big problem with this approach to valuing your startup is that it essentially gives you a “lowball” underestimated value. This is because the cost-to-duplicate calculation doesn’t reflect your company’s true potential for growth through sales, profits, and return on investment. Instead, it takes a limited snapshot through costs of physical infrastructure, equipment, and development. It also doesn’t factor in intangible assets like brand value, which can certainly take a startup a long way.
2. Market Multiples
The market multiple approach values your startup against recent acquisitions of similar companies in the market. This indicates to investors what the market would be willing to pay for the company, which is why venture capitalists tend to like this approach.
Rather than earnings, which are often used by established corporations to determine value, valuing your startup will often be based on revenue multiples in relation to other companies. Take mobile app software firms, for example, which are selling for five-times sales. You know real investors are willing to pay at this five-times multiple, so you could adjust the multiple up or down with your startup, depending on where you are in relation to the comparable businesses. Investors will often then provide funds when they believe in the company’s growth.
One con to point out is that comparable market transactions for startups can be difficult to locate. Especially when you’re trying to scout out comparable startups, you’ll realize many early-stage, unlisted companies keep their deal terms under wraps. However, the market multiple approach to valuing your startup will certainly provide a value estimate that comes closer to what investors are willing to pay.
3. Discounted Cash Flow (DCF)
A discounted cash flow analysis forecasts how much cash flow your company could produce in the future. Using an expected rate of investment return, you can calculate how much that cash flow is worth. This makes the DCF approach advantageous for startups relying on future potential to determine value. A higher discount rate to the end value is still usually applied to startups, which often have the risk of failing to generate sustainable cash flows.
More importantly, the DCF should be used with care. Valuing your startup with a quality DCF depends on how well your analyst can forecast future market conditions and make spot-on assumptions about long-term growth. The expected rate of return used for discounting cash flows can vary the DCF value widely as well. Projecting beyond a few years of sales and earnings becomes a guessing game.
4. Valuation by Stage
The development stage valuation approach is a favorite among angel investors and venture capital firms, which provides them with a more fleshed out range or timeline of company value. As your startup progresses along the development pathway created, the company’s risk decreases and its value increases.
A valuation-by-stage model might look something like this:
Estimated Company Value / Stage of Development
$250,000 – $500,000 = Has an exciting business idea or business plan
$500,000 – $1 million = Has a strong management team in place to execute on the plan
$1 million – $2 million = Has a final product or technology prototype
$2 million – $5 million = Has strategic alliances or partners, or signs of a customer base
$5 million and up = Has clear signs of revenue growth and obvious pathway to profitability
This is just an example, and the particular value ranges for your company and investor will vary. Most startups that only have a business plan so far will get the lowest valuations from their investors, and will progress as the company meets developmental milestones.
Private equity firms often take the milestone approach and provide funding in rounds. For example, an initial round of financing may help recruit employees to develop a product. Subsequent rounds provide funds to mass produce and market the product once it has been proven to be successful.
The Bottom Line
This is all to say that it’s difficult to pin down exact valuations for young startups. Because of the uncertainty of its success or failure, valuing your startup can be more of an art than a science. Nonetheless, even without solid revenue and earnings to base a valuation off of, one of these methods to valuing your startup can come in handy.
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