How to valuate a Startup? – The most important things you should know about.
Hi there! It’s our 6th article from the “Startup series”. Here are previous ones, so if you have passed them through – it could be also interesting:
- Stages of Startup Funding – A step-by-step guide
- What is startup capital?
- Typical Startup Equity: structure, employees, percentage
- Role of CEO in a Startup – The complete list of traits
- Financials for a startup
And today we will talk about how to valuate a Startup.
The world of venture capital investments is especially mysterious in terms of startup cost estimates. Investors are not too fond of publishing formulas and numbers and it gets many founders to wonder how to evaluate a startup? The cost of a startup is often more the result of agreements between the founders and the investor than the result of mathematical calculations. Nevertheless, there are some techniques and formulas that can be used as arguments in valuation negotiations with an investor.
An early-stage startup usually has (almost) no product users, (almost) no sales to link an estimate to which is different from evaluating a non-startup business: a cafe, a factory, or a car service. Most often, at an early stage, startup tools are a small but energetic team with internal motivation to move forward and change the world, an idea, sometimes a technology, a product, and maybe a small group of early customers.
In this case, only the experience of other startups that have advanced in development further than you can help with the evaluation.
Place, Time, and Medals
First of all, several important factors are involved in determining the value of a startup:
- the location of the team and customers (startups with the same performance in San Francisco, New-York, Copenhagen, Antalya, or Tel Aviv differ in costs which reflects the likelihood of their sale (exit) and the potential amount upon sale) ;
- the state of the market which the startup operates in (startups in the travel industry and startups in the field of remote education during the quarantine period are evaluated very differently which reflects the state and prospects of the market);
- competition (a startup that intends to compete with Google, Apple, Facebook, especially in the area of their free products, and startups with weak competitors are different stories);
- the depth and experience of the team (any startup that Elon Musk launches tomorrow or a team that has recently created a unicorn will be rated much higher than a startup created by a team without “medals”);
- the estimated length of the “valley of death” (long investments without rapid growth of audience and/or sales imply much higher risks than projects that give results quickly);
- the rate of sales growth and/or audience (companies showing fast and constant growth prove in such a way that they have correctly assessed the Product / Market fit);
- other “orders and medals” (companies with well-known clients and investors, companies that have a queue of investors behind them, companies in segments that are hot at the time of investment are more expensive).
How to estimate the cost of a startup right now, at least approximately
The cost of a startup at the idea stage, if it arouses the interest of investors, is between $100 – 500 thousand. However, in Silicon Valley, US it can be estimated at $1 million or in a much larger amount.
At the next stage, when there is already an MVP, the cost of a startup can reach several million dollars in the Valley and about a million elsewhere (or much more, taking into account the factors above).
As a startup has customers, sales, and traffic growth, its value begins to depend on these numbers, and startups whose business model involves selling at an early stage are usually estimated using revenue multiples: the sum of sales in the last month multiplied by 12 (months) and then multiplied by a multiplier. Typical multipliers for any industry in any year are fairly easy to find using Google: M&A researches and polls are published regularly. Mostly, these numbers range from 3x to 20x. Low multiples are used for less “hot” industries, for companies that are not developing rapidly, and for a market in a stagnation phase. High – for the most promising segments, the fastest-growing companies, and for the market in the phase of active growth.
A startup with rapid growth from month to month (and even more so from year to year), with funding from top investors, with excellent LTV, CAC, churn rate, with “star” founders, etc. can cost 50x per annum sales, and more, while a company that is quite similar to it in a superficial comparison can only count on an estimate less than ten, or even twenty times.
Popular methods for evaluating a startup
Venture Capitalist Method
With this method, the assessment is determined by the expected value of the startup at the time of exit and the investor’s profit at that moment. These are the same Xs that venture capitalists talk about – 10x, 8x. Suppose a startup is expected to be worth $100 million in 5 years, and the investor plans to earn 10x on this, that is, to increase his investment by 10 times. Taking into account future dilution by subsequent investments, with this calculation, the investor will be ready to invest in this startup, according to an estimate of no more than $10 million.
It is used at a very early stage in a startup. With this method, the evaluation is made up of a monetary value of five key factors: idea, prototype, team, strategic partnerships, sales. The cost of each of these factors can be at most $500 thousand. If some factor is not present in full, for example, the prototype is not fully developed, then the cost is reduced. The final valuation of a startup is obtained by adding the values of all five factors.
Copy Cost Method
This one is quite time-consuming as it requires deep analysis and assessment of creating a similar business from zero. This method allows you to assess the competitive advantages of a startup more soberly. If the cost of duplication is low, then the value of such a startup will be lower as well. If copying a business model turns out to be too expensive, then the startup value will grow as the complexity grows.
Business models with strong network effects are extremely expensive to replicate if the startup has already captured a significant chunk of the market. There are funds that specialize specifically in startups with a strong network effect.
The essence of this method is in comparing the assessed startup with a similar startup, which has already been assessed earlier in the investment round. It adds the difference into account in the value of the key metrics of both startups, for example, the number of users or customers, potential market size, risks, etc.
Let’s say you want to evaluate a mobile app that has 100,000 users. Knowing that a similar application was previously valued by an investor at $4 million with 200 thousand users, we can assume an app value of $2 million.
There is no perfect way to evaluate a startup, especially early on when a startup has almost nothing but a dream, a team, and a drive. The financial instruments Convertible Note, SAFE, and KISS have been developed specifically for early-stage startups the cost of which is so difficult to determine. These are loans based on the promise to issue and transfer the company’s shares in the next round of funding for evaluation, most often with a discount from the next round (and, as a rule, with a maximum “cap” – cap, which protects the investor from overvaluation).
There are other evaluation approaches, such as the discounted cash flow (DCF) method and the asset valuation method which we have not covered in this article. They tend to apply to more mature companies than early-stage startups.
We hope that the methods and examples presented in this material will help founders not only feel more confident in negotiations with investors but also better understand both investors and what needs to be focused on for the growth of their startup. More importantly, because investors come and go and the business must function and grow.