Having a startup business is a lot of work, and without the proper financial backing, your company might never manifest into the flourishing business you envisioned.
So how do you get your startup business off the ground? There’s no specific route to take with this, nor has anyone narrowed it down to a science.
This uncertainty is why a startup valuation is an essential tool for you as the startup’s founder to use. Startups are much smaller when compared to longer-running companies, which are publicly listed generally have clear information showing their growth and annual revenue, making it easier for an investor.
With a startup, there is not much data that people can use to make a decision. A founder will provide a well-researched prediction, giving the investor an idea of where their money will go. There may be a significant amount of data gathered, but for some startups, there isn’t that much information to go on.
When it comes to a startup business, investors can be persuaded into an investment when the founder can develop a well-thought-out pitch with evidence.
What is startup valuation?
Startup valuation is the process of calculating a startup’s worth or value. This process is not as straightforward as it may sound. There are many things to consider when getting your startup’s valuation done.
Startup valuation is expensive, but it is well worth it when it comes to your business’s future. Also, there are a few different methods that can be used: the EBITDA method, the valuation based on revenue and growth strategy, and the pre-revenue or early revenue method are just some you will encounter. In fact, you might even use a combination of these methods when coming up with a valuation for your startup.
Problems with startup valuation
Startup valuation is a great way to get your business the boost it needs to beat the competition. There are many ways to find the value of a startup; therefore, it is much easier to get such a task done. But what then are some of the issues that one might face in doing so?
If a business needs a capital injection, the founders will have to put in more money to get close to the desired outcome. They do this by using one or two of the following strategies, which are the most commonly used in these types of cases.
With the abundance of valuation processes available, you might ask yourself which to use. The most common is the EBITDA method, which stands for “earnings before, interest, tax, depreciation, and amortization.”
In this method, the startup’s annual revenue is calculated and used to decipher the business’s value.
The problem herein lies with the fact that startups don’t necessarily have an EBITDA if they are still in the early stages of development and won’t have specific statistics to show.
Valuation Based on Revenue and Growth
Another process you could use is the valuation based on revenue and growth. This valuation method is used mainly with startups that are primarily online. With this method, the startup’s revenue is multiplied by a negotiated multiple that everyone involved has agreed upon.
For example, suppose your startup has a 40%-50% growth in revenue. In that case, you could get a multiple of around 6-10, whereas a startup that is just in its beginning phases or is still just a concept that is making or predicted to have little revenue would probably get a multiple of about 1-2.
The problem with this method is that you might not get the funding you were hoping to get if your company is in its early stages.
Pre-revenue or Early Revenue Method
Another option is the pre-revenue or early revenue method. When a startup is not making a profit, it can use this method as a stepping stone to get to a proper valuation done.
With this method, a “loan” called a convertible note is given to the startup by investors that will convert itself into equity when the predicted revenue is made. One problem with this method is that it might not get you the capital you were hoping to get and could take your startup longer to get going.
Each of these methods are helpful and can be beneficial when you’re pitching your plan of action. The potential growth in a startup is tremendous, and the revenue being made is just an indicator of how much is possible if the business grows into something successful.
Which Points You Should Consider In A Defined Environment
When getting a startup valuation, many founders take for granted the importance of weighing their options and tend to jump straight into whichever option seems cheapest or most convenient. So to help broaden your understanding, here are some other options for you to consider when getting your startup valuation.
One of the crucial points to think about is the risk factor. A comprehensive and detailed risk analysis is a must for a proper decision to be made. When you have a business, an abundance of risks rise to the surface.
At first, it may not seem like there are that many risks to consider. But when you look through every detail and put each aspect of your startup under a magnifying glass, it becomes clear that you may need help with balancing your risk factor.
A solution to this is to use a process called Risk Factor Summation, which calculates how much of an asset or liability a pre-revenue startup is by looking at all the risks within the startup and all the risks that may arise.
When this method is in use, the startups’ overall risks are taken into consideration by investors and then used to determine if the company is high risk or not. Possible risks include the reputation of the startup, management, funding, marketing, or the startup stage — the most significant risk seen by investors is the management risk, and it can sometimes even be the deal-breaker.
Each of the risks is given a rating of between negative-2 to positive-2. When each has been rated, the results are added up and shared with the potential investors.
Another method you could use is the Scorecard Valuation Method, which uses funding given to previously valued startups to indicate how much the average financing is to fit your startup. The adjustment is made based on which stage the startup is in compared to the already funded company.
The information you’ll need to calculate varies depending on the pre-money valuation of the startups in the region it’s found in; then, compare your results to those of similar startups. The results could include the size of the opportunity, how strong the founding team is, revenue and sale, or additional capital required.
Again, investors will focus mainly on the management aspects of the startup and may put its importance above that of the others. The other evident focus would be the return on the investment and how much revenue would be made and turned into equity or return.
The Comparable Transaction Method is another option that can be used as an alternate valuation or a temporary fix for the startup. Similar to scorecard valuation, this method compares the transactions of a similar startup and the target startup and evaluates the data.
The more available the data, the easier the valuation becomes. This method tends to go hand-in-hand with the other ratio-based data from the company, like the price-to-sale ratio or the price-to-cash-flow ratio.
Of course, such data may not be readily available for startup companies like it is for a publicly listed company. However, this method can still be used to make an informed decision and can be used temporarily until more data is available.
How to define pre-money Startups evaluation
So what do you do when the startup doesn’t generate profit yet? It’s harder to evaluate it without some forecast formulas, so here are some tips to help you.
Simple Agreement for Future Equity (SAFE) is a strategy that comes into play or can be used when a company has little to no reliable information or revenue and can’t be valued accurately due to its lack of proper information.
This method allows a startup to delay its valuation until it is ready or it has gathered enough resources. This is done by means of convertible security that can either grow into shares of the company or be returned if the company doesn’t make what was predicted.
Discounted Cash Flow (DCF)
This method involves calculating a startup’s predicted growth by considering the sum of the startup’s cash flow within a period, then dividing this figure by the discount rate while adding one and multiplying it exponentially by the discount rate.
The formula is DCF=CF/(1+r)^n, and it is not as complex as it sounds. The DCF is used to calculate a startup’s ability to secure its revenue return and represents the amount of money an investor is willing to invest, given the right conditions.
Venture Capital Method
In this method, investors put money into a startup with venture capital, given they can exit the deal within 3 to 7 years. Before anything happens, the decision on an exit price is made, and a calculation of the value, post-money, of the startup is done. The time and risk taken by the investor are also taken into consideration. The return an investor can expect is based on the investment and its possible risks.
Startup valuation is a tricky process and is one of the tools that can make or break your company. Remember to consider every variable and don’t put all your eggs into one basket. Be sure to make use of more than one method or find the best combination of them that would be in your startup’s best interest. And when it feels like you’re doing the most and getting nothing out, remember that even the giants were all once startups that used these methods to build their businesses future.