We recently wrote about The steps to start a start up company in India and Top 10 Biggest Tech Companies in the World as of 2017 and their Market Values, let's now unfold another chapter of our exhaustive study on and about start ups- The most accurate Startup Valuation Methods.
What does Startup Valuation Mean?
Valuation in simple terms means the value of a company. When we measure the valuation of startup, we usually do it in two phases: pre-money valuation and the current valuation of a startup.
These Startup Valuation Methods are important because:
Investors need to make an informed decision and therefore these methods help them with making a decision.
Unlike well-established companies, startups don't have a past record, therefore these methods are the only way to get an idea of the possible future.
Let's now take a look at a few of the most accurate Startup Valuation Methods:
Before employing any of the below-mentioned Startup Valuation Methods, one must be aware and have a general idea of the factors that affect valuation:
Positive factors: Traction, Reputation, Prototype, Revenues, Supply and Demand, Distribution Channel, Hotness of Industry
Negative factors: Poor Industry, Low Margins, Competition, Management Not Up To Scratch, Product Desperation
1) The Berkus Method
"And in my opinion, all fail to take into account the universal truth – that fewer than one in a thousand start-ups meet or exceed their projected revenues in the periods planned."
David Berkus, a renowned author of the business angel investor invented one of the most famous valuation methods of all time- The Berkus Method. Investors investing in tech start ups use this method the most! This method was first introduced and published in 2001 in a book called "Winning Angels". But nonetheless, this method has undergone refinements with time making itself one of the most dynamic (and thus, accurate) methods for valuation of start-ups.
How it works:
Berkus says that the investor must first think (and believe) if the startup has the capacity of hitting a $20 million mark or more by the fifth year of the establishment? He allows half a million for the following five parameters/aspects:
Sound Idea (basic value of the product with moderate risks)
Prototype (Cutting down on technological risks)
Quality Management team (cutting down the execution risks)
Strategic relationships (Cutting down competition and market risks)
Product roll out and sales (Cutting down on production risks)
One of the drawbacks of this method is that it is excessively based on assumptions rather than evaluating the product and growth environment. Critics argue that there is an absence of conditional and subjective analysis. An example of this could be how this startup evaluation method does not take the competitive environment into consideration.
Nevertheless, it's a great method to evaluate the startup's valuation in the near future. Most investors do put this method into practice before investing.
2) Risk Factor Summation Method
This is also known as the RFS method and is a slightly advanced version of the previous method. As described by the Ohio TechAngels, this method is ”Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘Management Risk’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types.”
The Risk Factor Summation Method is mostly used for pre money valuation and for pre revenue companies. This Startup Valuation method can be broken down into the following steps:
Step 1: Determining the initial value
Before doing anything else, you need to evaluate the initial value of your startup. You can do this by taking into account the records and responses of other startups in the same field.
However, people have reported that the first step itself is the most challenging. It's difficult to find concrete data on other similar startups.
Step Two: Analyzing the Risks
The following risk factors need to be taken into consideration:
Management
Stage of the business
Legislation/political risk
Manufacturing risk
Sales and marketing risk
Funding/capital raising risk
Competition risk
Technology risk
Litigation risk
International risk
Reputation risk
Potential lucrative exit
The analyst needs to rate these risk facts with the following scale:
++ (excellent)- add $500,000
+ (good)- add $250,000
0 (neutral)- no change
– (poor)- subtract $250,000
–– (excessively poor)- subtract $500,000
Via this method, the investors can thus get a fair valuation for how the startup performance is going to be in the near future.
3) Discounted Cash Flow Method
The one that Nike used!
Well, here's the good thing and bad thing about this method:
It's going to be the most accurate one.
It's the most complicated one too! So, a slight mistake or miscalculation can just make the product haywire.
The Discounted Cash Flow method or the DCF method is very commonly used not only by startups but by huge firms like Nike too! While the above two methods can be employed when the startup is just at its birth, this one has a different approach. It can be applied only after startups gain a little history of data. If one wishes to apply this method at the beginning stage of a startup, then assumptions and guesswork can be bought into play.
How it works:
To put it in simple terms, the cash flow that has come in the past years is taken into account. This is counted on a yearly basis as is known as the terminal value (TV). The TV is equated to the projected value after making certain factors like the discounted rate and the growth rate being subtracted and added respectively.
Mathematically, it can be broken down into the following:
TV = CF (n) + 1/ (r-g)
Here,
TV= Terminal value
CF= Cash Flow
n = Number of years
r= Discounted rate
g= Progress rate
Usually, a higher discount rate is applied to new startups considering the risk that the company might fail.
4) First Chicago Method
A lot of new age startups have used this method and have given brilliant reviews on it . The above-mentioned methods don't suit all kinds of startups. You're likely to be left saying, "What if there is no past record to consider from? Or what if we don't have access to the data of any other similar company?" This model is precisely the answer to those questions!
The first Chicago method gets its name from the first bank in Chicago. It puts into practice two kinds of approaches:
Market oriented
Fundamentally analytical
Using this method you will be able to consider events with low possibility yet a huge impact and this is certain to affect the valuation value directly.
How it works:
First and foremost, lay down the three possible scenarios for the startup: Best case scenario, worst case scenario, and Mild case. Do an in-depth analysis of what the cash flow, revenue, asset generation and growth will look like in each of the cases. Keep a close eye on the potential risk factors as well. This first step is going to be highly exhaustive and prolonged. But do remember, this step is extremely important as it'll form the bedrock of this method. Mistakes and carelessness here will yield the most inaccurate results.
After this, estimate the disbursement value (similar to the concept of terminal value explained above) and calculate the subsequent required return. For each scenario, the sum of the discounted terminal value and the discounted cash flow will be the valuation ground until the exit horizon.
In the end, to get a final number, keep the three possible valuation values in front of you (best case scenario, a mild case, and the worst case scenario). Most analysts generally take 70% value of the mild case scenario, 10% value of the best case scenario and 20% value of the worst case scenario.
5) Venture Capital Method
This is one of the best Startup Valuation Methods. It is completely from the point of view of the investors rather than the entrepreneur. Professor Bill Shalman first introduced this in the famous Harvard Business School in 1987.
How it works:
The investors here are usually looking for an exit in about three to seven years. The analyst first calculates an exit price and then later dwells into the post money valuation. This is done by calculating back, this time along with the time and the risk factors into consideration. It's likely to produce more optimistic and high valuation values than most other methods as this one is completely based on the future statistics.
This reverse calculation will help the investor understand what they can expect in return and the risk factors will reveal how much is at stake.
Mathematically, the formula is:
ROI = TV + PM
Alternatively, you can also apply:
PM= TV ÷ Anticipated ROI
Here,
ROI= Return on Investment
TV= Terminal Value (The selling price of the startup, after 5-8 years)
PM= Post Money Valuation
Our Verdict:
Because we are talking about the most accurate Startup Valuation Methods here, we must also remember that no matter how accurate these methods are, there's always scope for mistakes and discrepancies. Consider the following as the most common mistakes people make while valuating a start up:
A valuation is often considered as a permanent, universal and unchanging number. However, that's not quite true. Especially with startups, the valuation is likely to fluctuate. The goal here is to reach as close to the real value as possible.
People also tend to assume that the value is straightforward. Of course, it's not. For a startup, the future is always blurred from the starting line, you never know what influencing factors are to come your way.
Miscalculations are one of the biggest mistakes you can make. Since most of these Startup Valuation Methods involve taking assumptions, it's better to have an analyst who is experienced. The analyst takes the important call of the assumed values- so make sure it's done right!
Did you know?
DropBox and Instagram, two renowned Tech Startups are currently valued above $1 billion. But do you know what their pre valuation was?
For DropBox, it was 400K.
And for Instagram, it was $2.5Billion.
Thus, evidently, approach matters. Make a wise pick while choosing the right Startup Valuation Methods. Just to be safe, do the valuation using multiple methods. You may find it exhausting, but in the end, it'll be worth all the efforts. Good Luck!
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