For every startup, there comes a time when serious numbers have to be crunched. Not just the KPIs and ongoing metrics, but the big numbers. At some point, you'll need to calculate the value of your entire business, including your product, service, and customer value. In this article we examine how to calculate the startup value, how different valuation methods work, and what problems may occur if the numbers are too high or too low.
How to Calculate the Value of a Startup
At any given time, it's good to have a general sense of your startup's worth. Often, this isn't easy if you're in the early stages. Established businesses have assets, solid metrics, a good customer base, and profits (hopefully). Therefore, a company's value can be determined easily. As a startup, you might be missing some of these key factors, making it harder to calculate the value. Your company's growth should also be considered. The primary objective of startup businesses is to accelerate as quickly as possible. Changes in the market, your sales team, and your product's strength can all play a role in assessing your startup's value at a certain point in time.
Whether you're applying for venture capital financing, making minor investments, doing startup funding, or looking to sell your company, your startup valuation method must be appropriate. If you want to attract investors, you must be absolutely transparent about your financial data before you solicit their money or even consider getting involved with your business. Likewise, you don't want to find you made a critical valuation error that leaves you out of pocket in the long run.
Pre-Money Valuation vs. Post-Money Valuation
When calculating a startup's value, it's crucial to recognize these two startup valuation methods. The pre-money and post-money valuations assist investors in calculating the risk of investing in you, as well as how much they are willing to put down. When you're looking for external funding, you should distinguish between these two valuation methods. A pre-money valuation is the value of a startup before it receives any external funding or investment. This type of valuation gives investors an idea of the current value of a startup, as well as any shares that have been issued. Post-money valuations can be determined once a startup has secured outside funding and funding rounds. When you're trying to get equity investors, these two startup valuation methods can affect your financing plans and ownership percentages. As a startup, those percentages may seem small, but in the future they could represent millions of dollars if you decide to go public.
Common Startup Valuation Methods
The valuation of a startup is never an exact science, especially at an early stage. Factors can include your industry, the current market, your team’s credentials, and other surrounding forces that might be taken into account. Your startup's valuation is the amount investors think your business is worth right now. A lower startup valuation is likely if the market your product operates in isn't that popular - or if it's in a popular space experiencing a steep downturn. Startups can command a higher price tag if they have an in demand product in a performing market. Various startup valuation methods are available based on the type of company and the stage of growth. Here are four of the most common methods.
1. Comparable Pricing Method
This is one of the simplest methods for valuing startups. Use a company that is similar to your own (e.g. similar MRR growth, churn rates) as an anchor for your own value. Despite not being incredibly accurate, this is a good starting point for early-stage valuations.
2. Scorecard Method
Angel investors typically employ this startup valuation method, which is a variation on the comparison method above. Based on subjective comparisons of measure of success (team experience, quality product, competitors, etc. ), you can compare your startup with other "average" startups in your field. Your startup may get a higher valuation if its qualities appear to be above average according to their calculations.
3. Discounted Cash Flow Method
Based on this method, startup valuations can be estimated based on the long-term cash flow a company will generate. Assumptions can be made about the value of a startup by forecasting this and calculating the expected rate of return. This method is not the most reliable since it depends on the analyst's ability and the discount rate they use to take high-risk factors into account.
4. “Cost to Duplicate” Method
The following calculates the cost of launching the same startup from scratch. In a SaaS startup, this might include things like the cost of programming and designing the product. Additionally, it may include any physical assets the startup possesses, or research and development costs.
Although this valuation method can be tied to existing expense records and receipts to provide a good overview of the cost, it does not include the potential for growth, future sales, return on investment, or intangible assets like brand loyalty. Typically, this means that the startup is valued below its actual worth.
Startup Valuations That Are Too High or Too Low
It might seem that a miscalculation in either direction won't cause too many problems for your startup. A few dollars here and there won't seem like a big deal right now, but as your company expands, those missing (or extra) amounts will become problematic. By undervaluing your startup, investors will reap the benefits - and more equity in your business. Obtaining early funding at a low valuation can mean losing a lot of equity. In turn, this translates into a diluted company valuation and less equity to offer for future investors. Conversely, if your startup is overpriced, you can raise more funding without losing too much equity. Doesn't that sound better?! Of course, there's a catch. An unreasonable sum can sometimes attract unscrupulous investors who are interested only in the dollars, not the growth and success of your business. Keeping the value inflated for future rounds of funding may also prove difficult. Those who enter into a partnership with you under the impression that you have a high valuation might become increasingly resentful of their decision. Once they realize that you're not doing as well as you promised and are now finding it difficult to fulfill your promises and meet milestones, things can quickly go south. It's important not to deceive your investors to gain extra funding when starting a new business relationship with them.
Final Thoughts on Startup Valuation Methods
In conclusion, different startup valuation methods provide differential results at various stages of growth - and knowing when to use one method over another is essential. It is important to weigh the pros and cons of each method, and investors may prefer one over another. Whichever method you choose and whatever stage your startup is at, it's important to use accurate numbers when calculating the value. Ensuring you make the most of external funding opportunities while keeping control of as much equity as possible as your business grows.