There’s a time for every startup when some serious numbers need to be crunched. Not just the KPIs and ongoing metrics, but the big numbers. At some point, you’ll need to sit down and calculate the valuation of your entire business including your product, service, customer value – and your idea itself.
We take a look at how to calculate the value of a startup, the different startup valuation methods you can use, and the problems you might encounter if your numbers are too high or too low.
How to Calculate the Value of a Startup
It’s always good to have some sort of idea about the worth of your startup at any given time. If you’re at an early stage this often isn’t easy. Established businesses have assets, solid metrics, a good customer base, and (hopefully) profits. This means the worth of a company can be easily worked out. As a startup, you might be missing some of these key factors, which makes calculating the value of your startup a little bit harder.
You also need to factor in your company growth. Startups are typically high-growth business models that are looking to accelerate as fast as possible. Elements like changes in the market, your sales team, and the strength of your product can all come into play when you’re trying to predict your growth rate and calculate the value of your startup accordingly.
If you’re thinking about serious venture capital investments, minor investments, applying for startup financing or are looking to get bought out by a bigger player, it’s crucial to get the math right with the right startup valuation method. Anyone looking to invest in your company needs absolute transparency around your financial data before they hand over a cent and get involved with your company. Likewise, you don’t want to find you’ve made a critical mistake in valuation that means you’re out of pocket in the long term.
Pre-Money Valuation vs. Post-Money Valuation
When learning how to calculate the value of a startup, it’s important to have a clear understanding of these two startup valuation methods. Pre-money and post-money valuations help investors calculate the risk of working with you, and the amount they’re willing to invest. It’s important to distinguish between these two valuation methods when you’re looking into external funding.
Pre-money valuation refers to the worth of a startup before it receives any external funding or investments. This gives investors a clear picture of the current worth of a startup, and also the value of any shares that might have been issued.
Once a startup has received outside financing and funding rounds, post-money valuations can be calculated.
These two startup valuation methods can affect financing and your ownership percentages, if you’re looking at getting equity investors on board. Even if those percentages are small as a startup, they could mean a difference of millions of dollars if your company goes public further down the track.
Common Startup Valuation Methods
Startup valuation is never an exact science, especially for early-stage businesses. Factors can include your industry, the current market, your team’s credentials, and other surrounding forces that might be taken into account. A startup valuation is the measure of how much investors think your company is worth right now.
For example, if the market your product operates in isn’t that popular – or it’s in a popular space that’s experiencing a steep downturn – then your startup valuation is likely to be lower than companies that are experiencing the opposite situation. If you’ve got a smoking hot product in a hot market, you can place a higher price tag on your startup.
There are multiple startup valuation methods you can use to establish pricing, based on the type of company and the phase of growth it’s in. Four of the most common startup valuation methods are listed below.
1. Comparable Pricing Method
This is one of the simplest startup valuation methods. Find a company that’s comparable to yours (e.g. similar MRR growth, churn rates), and then use this as an anchor for your own value. While this isn’t incredibly accurate it can be a good starting point for early-stage valuations.
2. Scorecard Method
A variation on the comparison method above, this startup valuation method is typically used by angel investors. By weighing up measures of success (team experience, strength of product, competition etc.) subjectively, it enables comparisons between your startup and other “average” startups in your industry and area. If your startup looks to have above-average qualities according to their calculations, then the chances are you’ll get a higher valuation – and become a promising investment opportunity.
3. Discounted Cash Flow Method
This startup valuation method approximates how much cash flow a startup will produce over the long term. By forecasting this and calculating the expected rate of investment return, assumptions can be made about the value of a startup. This method isn’t the most reliable as it relies on the abilities of the analyst and the discount rate they use to take the high-risk factors of the startup into account.
4. “Cost to Duplicate” Method
This looks at how much it would cost to build the same startup from scratch. For a SaaS startup, this might include things like the cost or time taken to program and design the product. It might also include research and development costs, or any physical assets the startup has.
While this startup valuation method can be tied to existing expense records and receipts to provide a good overview of the cost, it doesn’t take into account the potential for growth, future sales, and return on investment, or intangible assets such as brand loyalty. This usually means the startup is valued below its actual worth.
Startup Valuations That Are Too High or Too Low
You might think that a miscalculation in either direction isn’t going to cause too many problems for your startup. While it’s true that a few dollars here and there might not mean much right now, as your company grows, those missing (or extra) amounts can start becoming a problem.
If you undervalue your startup, any investors are going to get the benefits – and more equity in your business. If your valuation is lower than it should be and you get some hefty funding at an early stage, this could mean losing a lot of equity. In turn, this means you have less equity to offer for any future investors as the value of your company has been diluted.
On the flipside, if you overvalue your startup, it technically means you can raise more funds without losing as much equity. Sounds like a better deal right?! But there’s always a catch.
Putting an unreasonable sum on your startup can sometimes attract the wrong kind of investor that’s just in the deal for the dollars – not the health and prosperity of your business. You might also find it difficult to keep inflating the value to attract future funding rounds.
Investors entering into a partnership with you under the impression that you have a high valuation might become increasingly resentful of their decision to do business with you. Once they realize you’re not doing as well as you had them believe on paper and are now finding it difficult to follow through on your promises and meet milestones, things can quickly turn sour.
When starting a new relationship with potential investors, it’s best to have a positive or favorable start, so it’s important not to deceive your investors into giving you extra funding.
Final Thoughts on Startup Valuation Methods
In conclusion, different startup valuation methods provide distinctive results at various stages of growth – and it’s important to know when one method is more appropriate to use over another. Each method has pros and cons that should be considered and investors may prefer one method over another. Whichever startup valuation method is right for you and the stage of business that you’re at, it’s important to be as accurate as possible with the numbers. This ensures you can make the most out of external funding opportunities while keeping as much equity as possible in your control as your business grows.
At Lighter Capital, we’re revolutionizing the business of startup finance – we don’t rely on valuations when we make funding decisions. After financing over $150MM in more than 500 rounds to tech startups, we’ve decided to share some hard-won insights.
Download our free Alternative Finance Industry Report (e-Book) in which we explore the changing landscape of tech startup financing, highlighting the growing trend of alternative options like revenue-based financing.
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