So you started a brilliant new company and want to understand what it's worth. How do investors slap a price tag on the blood, sweat, and tears you poured into this promising startup? As it turns out, startup valuation is both an art and a science.
Let's break down the main methods investors use to value early-stage companies. We'll explore how each approach works when it applies best, and what the key variables are. Light examples will help us see how the valuation sausage gets made!
The Cost Approach
The cost approach seems simple enough - add up everything you put into the company so far. This includes hard costs like equipment, software, employees, office space, etc. It can also factor in the opportunity cost of your time as the founder.
For example:
- Servers and cloud computing: $5,000
- Software and tools: $1,500
- Salaries already paid: $100,000
- Value of your time (1 year at $150K salary): $150,000
Total cost value = $256,500
This approach works well for asset-heavy businesses like manufacturing. However, it breaks down for startups based on intellectual property and rapid growth. Your bright ideas and future potential barely factor in!
The Market Approach
Instead of looking backward at costs, the market approach peers into the future. It bases the valuation on what comparable startups recently sold for.
For example, if a similar startup with comparable traction sold for $1 million, that's a starting point to value yours. Investors apply multiples like 2-3x to account for differences and growth potential.
The key is finding "comps" - startups in the same domain, vertical, size, and stage. But no two startups are exactly alike, so professional judgment must fill the gaps.
The Income Approach
This method forecasts future revenue streams. It applies industry-standard multiples to values like:
- Revenue
- EBITDA (Earnings Before Taxes, Interest, Depreciation)
- P/E (Price/Earnings) Ratio
- Discounted Cash Flows
The income approach requires financial modeling and bold assumptions. Variables like market size, prices, adoption rate, margins, risk rates, and time to exit are complex.
But when based on defensible assumptions, the income method captures a startup's true earning potential. This is why VCs pay close attention to traction and unit economics.
The Venture Capital Method
The VC method focuses on high-growth tech startups. It cares more about hypergrowth and market leadership potential than current revenue.
VC valuation relies heavily on the terminal value - what the company could be worth if the hockey stick growth plan pans out. This terminal value gets discounted back to today's dollars at the company's risk rate.
So even no-revenue startups can be valued at tens of millions! But it requires a rosy projection of the future, discounted appropriately for risk and uncertainty.
The Berkus Method
Somewhere in between the cost and income approach lies Dave Berkus's simplified model. It has only 5 variables:
- Sound Idea: $500K
- Prototype: $500K
- Quality Management Team: $500K
- Strategic Relationships: $500K
- Product Rollout/Sales: $1M
Just add up the factors that apply and exclude those missing. The Berkus method works quickly when needed for funding rounds. But it's less rigorous than modeling future cashflows.
The Risk Factor Summation Method
This approach adjusts valuation based on a weighted scorecard of risk factors like:
- Management experience
- Business stage
- Competition
- Marketing/sales channels
- Technology edge
- Intellectual property
Each factor has a risk score from 1 to 5. The scores get summed and the total maps to a valuation discount from 20% to 90%.
Easy to calculate, but the risk scores are quite subjective. Also, the maximum 90% discount seems extreme, capping the valuation at just 10% of a similar business without those risks.
Key Takeaways
And there you have it - six leading methods investors use to value startups and early-stage ventures. Each approach has pros and cons:
- The cost method is simple but static.
- Market comps provide orientation but every business is unique.
- The income method models earning potential but relies on assumptions.
- The VC method focuses on future growth but applies high discounts.
- The Berkus method is quick but less rigorous.
- Risk factor summation adjusts for red flags but the scores are subjective.
Smart investors use multiple methods to triangulate. They also emphasize alignment - ensuring founders and investors agree on assumptions and milestone-based financing. What matters most is not the initial valuation, but sharing upside in the ultimate vision for growth.
So don't stress too much on today's valuation. Instead focus on accelerating traction, derisking the major milestones, and communicating clearly with investors. The rest tends to work itself out when you turn vision into reality one step at a time.
Now armed with an overview of common startup valuation methodologies, may your fundraising conversations bear fruit! Consider this article a starting point for further learning and term sheet negotiations.
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