Have you ever wondered how these valuations were calculated?
Compared to established and publicly listed companies, assessing the valuation of a startup can be extremely challenging. There is a severe lack of visibility into the performance record, business strategies, and financial strength. Even startup insiders may stumble due to a lack of operational and financial history.
Despite these challenges, valuations must be estimated to determine investment terms, track performance, and for financial reporting and compliance reasons. In this article, we will discuss 8 methods that are regularly used in the venture capital space to circumvent these challenges.
Startup valuation methods for investors and founders
A startup’s valuation impacts potential dilution, investment returns, and assists founders in tracking performance. There are various methods to calculate valuations, each of which is constructed with a different purpose and applicability in mind.
The following discussion will help you choose the right valuation method for the situation at hand and shed light on why valuations can vary so widely in negotiations.
Discounted cash flow method
When your startup starts generating revenue, you can find its valuation using financial projections. A widely accepted method to do so is called the discounted cash flow method. Under this method, you must forecast your startup’s cash flows based on expected growth, lifespan, interest payments, and capital expenditures. Then, you must discount these cash flows and find their total present value. In startup valuations, the expected return rate is used as the discount rate.
Finally, you must add the terminal value to the total present value of cash flows to arrive at your startup’s valuation. The terminal value is nothing but the expected gains from winding up your startup. You can calculate this by subtracting the expected liabilities from the expected assets at the end of your startup’s expected lifespan.
Let us understand this through an example where the financial projections are as follows.
| Type of financial data | Actual | Projected | ||||
| Year | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 |
| Net income | $1,000,000 | $1,050,000 | $1,102,500 | $1,157,625 | $1,215,506 | $1,276,282 |
| (+) Depreciation and amortization (D&A) | $60,000 | $60,000 | $60,000 | $60,000 | $60,000 | $60,000 |
| (-) Change in net working capital | $100,000 | $45,000 | $30,000 | $80,000 | $60,000 | $20,000 |
| (-) Capital expenditures | $400,000 | $0 | $0 | $300,000 | $0 | $0 |
| (+) Net borrowing | $250,000 | $0 | $0 | $150,000 | $0 | $0 |
| Free cash flow to equity (FCFE) | $810,000 | $1,065,000 | $1,132,500 | $987,625 | $1,215,506 | $1,316,282 |
Suppose we also know that the terminal value of the firm is $5 million at the end of the projected period of 5 years. Now, we can discount the FCFEs and the terminal value using a discount rate of 6% to arrive at their present value.
| Year | FCFE and terminal value | Discounting factor | Present value |
| 2025 | $1,065,000 | 1.06 | $1,004,717 |
| 2026 | $1,132,500 | 1.1236 | $1,007,921 |
| 2027 | $987,625 | 1.191016 | $829,229 |
| 2028 | $1,215,506 | 1.26247696 | $962,795 |
| 2029 | $1,316,282 + $5,000,000 | 1.338225578 | $4,719,893 |
| Company valuation | $8,524,555 | ||
Thus, the discounted cash flow method helps us arrive at the company valuation of $8.52 million.
Berkus method
The Berkus valuation method is often used to value early-stage startups that lack a financial history. Its purpose is to prevent overvaluation by introducing a valuation cap. As per the latest update, under this method, up to $500,000 is added for a startup’s progress towards the following milestones:
- Sound idea
- Prototype
- Quality management team
- Strategic relationships
- Product rollout or sales
The maximum achievable valuation under this method is $2.5 million. The simplicity of this method allows you to modify it to suit different industries and market conditions.
Example
Suppose you rate a particular company in the following manner:
- Sound idea: 60%
- Prototype: 75%
- Quality management team: 100%
- Strategic relationships: 80%
- Product rollout or sales: 50%
Then, as per the Berkus method, you can value this company as follows.
| Criteria | Score | Value |
| Sound idea | 60% | $300,000 |
| Prototype | 75% | $375,000 |
| Quality management team | 100% | $500,000 |
| Strategic relationships | 80% | $400,000 |
| Product rollout or sales | 50% | $250,000 |
| Total company valuation | $1,825,000 | |
Scorecard method
The scorecard method is also frequently used to value pre-revenue startups. The first step in this method is to find out the average valuation of similar startups. Then, you must evaluate how your startup compares to the industry norms based on certain attributes. For instance, your technology might be superior to the kind developed or used by other startups, so you may assign a score of 110% for the technology attribute. Then, you must calculate the weighted sum based on the following weights:
- Board, entrepreneur, and the management team: 30%
- Size of the opportunity: 25%
- Technology/Product: 15%
- Competitive environment: 10%
- Marketing/Sales: 10%
- Need for additional financing: 5%
- Others: 5%
The weighted sum must then be multiplied by the average valuation of similar startups. These weights can be adjusted to suit different industries.
Suppose you are valuing a seed-stage SaaS startup, and your research enabled you to come up with the following scorecard:
- Board, entrepreneur, and the management team: 110%
- Size of the opportunity: 100%
- Technology/Product: 80%
- Competitive environment: 150%
- Marketing/Sales: 80%
- Need for additional financing: 80%
- Others: 140%
You also know that the average seed-stage startup is valued at $3 million.
Based on this, you value the company in the following manner.
| Criteria | Weightage | Score | Weighted score |
| Board, entrepreneur, and the management team | 30% | 110% | 33% |
| Size of the opportunity | 25% | 100% | 25% |
| Technology/Product | 15% | 80% | 12% |
| Competitive environment | 10% | 150% | 15% |
| Marketing/Sales | 10% | 80% | 8% |
| Need for additional financing | 5% | 80% | 4% |
| Others | 5% | 140% | 7% |
| Total weighted score | 104% | ||
| Company valuation | $3,120,000.00 | ||
Comparable transaction methods
This valuation method involves establishing a market valuation multiple by dividing the total valuation of similar companies by a relevant financial metric, such as total revenue. Then, you must multiply your startup’s financial metric by the market valuation multiple to arrive at your valuation. Since this valuation method effectively aligns a startup’s valuation with market conditions, it is favored by investors.
Let us see an example where you are valuing an AI startup with an annual revenue of $2 million. Suppose that its peers’ valuations and annual revenues are as follows.
| Company name | Valuation | Annual revenue |
| NeuraVision | $48,000,000 | $6,200,000 |
| LogicLayer AI | $42,500,000 | $5,100,000 |
| SynapseFlow | $35,800,000 | $4,700,000 |
| DeepIndex Labs | $31,200,000 | $3,800,000 |
| CogniMetric | $27,000,000 | $3,300,000 |
| AetherMind | $22,600,000 | $2,750,000 |
| QuantaForge | $19,900,000 | $2,200,000 |
| VertexAI Systems | $17,400,000 | $1,950,000 |
| Intellecta | $14,700,000 | $1,600,000 |
| DataNova AI | $11,300,000 | $1,100,000 |
| Total | $270,400,000 | $32,700,000 |
| Market valuation multiple | 8.27 | |
Now, you can calculate the AI startup’s valuation as the product of its annual revenue ($2 million) and the market valuation multiple (8.27), which would be $16,538,226.
Cost-to-duplicate method
The cost-to-duplicate method involves estimating the cost of building an identical startup from scratch. Under this method, you must add the present value of your physical assets to the expected costs for building the identical startup. Since only physical assets are considered, intangible assets such as goodwill, patents, and other intellectual properties get overlooked.
This valuation method’s major flaw is that it doesn’t account for the value derived from the business’s reputation and cash flows. Hence, it is seldom used in practice for revenue-generating startups. However, you may still utilize it to form a minimum baseline valuation for your startup.
So, suppose your startup’s physical assets are valued at $2 million and the estimated cost to replicate the business is $500,000, then under the cost-to-duplicate method, the startup’s valuation would be $2.5 million.
Venture capital method
When your startup is highly likely to provide a valuable exit to an incoming investor, you can use the venture capital method. First, you must estimate the period after which you can provide the exit and your startup’s expected valuation on the exit date. The expected valuation on the exit date can be calculated based on the valuations of similar startups that have reached the IPO or acquisition stage.
Then, you must discount the expected valuation by using the investor’s expected return on investment (ROI) as the discount rate.
By doing so, you will arrive at the post-money valuation. Then, you must subtract the investment amount from the post-money valuation to arrive at your pre-money valuation.
Suppose your expected valuation at IPO five years from now would be $100 million, and your incoming investor, who will be investing $12 million, expects an annual return of 20%.
Then, your post-money valuation = Present value of the expected valuation
= Expected valuation / ( 1 + Expected return rate)Number of years
= $100,000,000 / ( 1 + 20%)5
= $100,000,000 / 2.48832
= $40,187,757
Then, your pre-money valuation = Post-money valuation – Investment amount
= $40,187,757 – $12,000,000
= $28,187,757
Thus, based on the venture capital method, your pre-money valuation would be $28.19 million.
Asset-based method
In the asset-based valuation method, you must simply subtract the total liabilities from the total assets. Like the cost-to-duplicate method, this valuation method overlooks the value created by a business over its operation in the form of goodwill, brand recognition, and market penetration. So, this method is typically not used in funding rounds, buybacks, and most other scenarios. However, this valuation method is used to estimate how much investment could be recovered in the event of dissolution.
Suppose your startup’s total liabilities are $12 million and its total assets are $45 million. Then its valuation would be $33 million as per the asset-based method.
Risk factor summation method
The risk factor summation method can be thought of as an extension to any of the other valuation methods discussed thus far. It requires an initial valuation, which must be calculated using a different method. Then, you must make positive or negative adjustments to this initial valuation depending on various business risks. Businesses are exposed to a wide range of risks, including liquidity risks, operational risks, political risks, and economic risks. You must identify which risks are relevant given your startup’s size, industry, geographical diversification, and assumptions and characteristics of the valuation method used to calculate the initial valuation.
Let us continue our previous example. Suppose you know that your startup’s exposure to the relevant risks is as follows:
| Risk factor | Risk exposure |
| Economic | $2,000,000 |
| Industry | $6,000,000 |
| Operational | $8,000,000 |
| Liquidity | $4,000,000 |
| Total risk exposure | $20,000,000 |
Now, we adjust your company’s valuation by subtracting the total risk exposure ($20 million) from the previous valuation. By doing so, we will arrive at a valuation of $13 million.
Simplifying financial operations and compliance for startups!
In addition to funding rounds, accurate valuations are necessary for issuing stock-based compensation from a compliance perspective. The fair market value (FMV) of your startup plays a key role in determining your employees’ tax liability. By delivering accurate and affordable valuations, Eqvista enables startups to conserve cash reserves, boost morale, and maintain tax compliance. Connect with their team today to start leveraging stock-based compensation in your hiring strategy.
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