Valuing a startup is a complex and challenging task because there are many factors to consider and there is often a lack of historical financial data to rely on. That’s why there is a lot of confusion on how you should value a startup, whether you are raising funds or simply assessing the value of your own shares.
In this article we’ll look at how you can approach the valuation of a startup, using 5 simple steps. More importantly we’ll look at what are the factors that impact a startup valuation, and the methodology you can use to calculate it.
Determine the stage of the startup
The valuation of a startup will depend on its stage of development. For example, a pre-revenue startup will be valued differently than a company that has been in operation for several years and has a proven track record of revenue and profitability.
Indeed, whilst investors would value the former based on things like: the team’s experience and track record, the barriers to entry, the market size and the product itself, we would instead give more emphasis to financial projection when we value later-stage startups.
Identify the market size and competition
It’s important to consider the industry size and growth potential of the market in which the startup operates.
For example, a startup operating in a rapidly growing market with a large addressable market is likely to be more valuable than a startup operating in a stagnant market with a small addressable market.
In addition, investors will want to understand the competitive landscape in which the startup operates. This includes identifying the company’s competitive advantage and understanding the competitive threats it faces.
Assess the founding team
The experience and expertise of the startup’s founders and management team can have a significant impact on the value of the company. Investors will want to see a strong leadership team with the skills and experience necessary to execute on the company’s vision.
Prepare financial projections
Estimating the financial projections for the startup can help determine its value. This includes forecasting the company’s revenue and expenses over a period of time (usually 5 years).
Preparing financial projections for a startup can be a complex task, as it involves making assumptions about the future growth of the company and the market in which it operates.
To do so, make sure to identify and understand the key drivers of the business and how they are likely to impact the company’s financial performance.
This can be the number of visitors (web traffic for example), the footfall of a store or even macro economic factors (for example the strength of the real estate market).
Use a valuation methodology
There are several methods that can be used to value a startup, the most important ones being the venture capital valuation methodology for early-stage startups, the comparable company analysis method and the discounted cash flow method (DCF) for mature companies.
Each method has its own strengths and limitations, and it’s important to choose the right method based on the specifics of the startup and the available data.
Venture capital valuation method
The venture valuation method is a popular methodology by venture capital firms and angel investors worldwide to value early-stage startups.
The logic is as follows:
- First, we must calculate what we call the “exit valuation”: the valuation of the startup in 5 or 7 years time based on its financial projections using a revenue multiple (see below), for example $100 million
- Then, we discount the exit valuation to find the corresponding valuation as of today, using an investor’s rate of return (or “Internal Rate of Return”, the IRR)
Valuation multiple methodology
This method values a company based on the valuation of similar companies in the same industry or market. This involves identifying comparable companies and using their financial metrics and valuation multiples to estimate the value of the company being valued.
Often, we simply use revenues for early-stage startups (as their profit metrics are negative) and EBITDA (or sometimes even net profit) for mature startups.
This method is the easiest one. For example, assuming we value a startup using its revenues and we find that comparables companies are valued at 10x their revenues, valuation simply is equal to:
Valuation = Revenues x 10
Discounted Cash Flow method (DCF)
This method values a company based on the present value of its future cash flows, discounted at an appropriate rate to account for the risk and uncertainty associated with the company.
The DCF method involves making assumptions about the company’s future growth and profitability, and it is typically used for companies that have a proven track record of revenue and profitability.
As such, DCF is only useful for mature companies and not very common for startups. We only use it for low-growth startups (brick-and-mortar businesses like restaurants, hotels, etc.) and not high-growth businesses (e.g. digital startups).
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