Common methods for valuing startups. What information is needed to evaluate a company and where to look for it?

Valuation of a startup is the process of determining its value, based on an analysis of a number of indicators. A full-fledged valuation of a startup requires information on revenue, risks, profits and losses, and other data. 

The goal is to provide entrepreneurs and investors with more visible tools to make decisions regarding the purchase, sale or financing of a startup.

What is a startup valuation?

A characteristic feature of an evaluation is that it is biased. In addition to real factors, subjective assumptions and crude assumptions are used, such as an approximate forecast of sales growth over the next three years. Thus, a startup valuation should be perceived as a reasonable assumption at best, with all the uncertainties taken into account. 

Why and who needs a startup valuation?

There are two ways to value a company: through market value and intrinsic value.

Market value, obviously, reflects the valuation from a market perspective. It is influenced by the economic situation and can change under external factors, and because of that, businesses can be over- or under-valued. Market valuation is more often given to public companies. Startups tend to remain private and are not publicly traded on the market. 

Intrinsic value is a reflection of the real price in isolation from the current market; it is less affected by the economic situation. In the case of startups, which usually have no market valuation, it is the intrinsic value that investors focus on. 

The valuation of a startup allows analysts to calculate its intrinsic value with less regard to the market. However, analysts are far from the first beneficiary. 

The first beneficiaries of startup valuation are founders. The data is used for the following processes:

• selling the startup or stakes in it, calculating shareholder value;
• better communication with investors in search for investments;
• building trust in a startup through transparent valuation;
• calculating the value of options purchased or acquired by employees;
• calculating taxes for employees who own stock or options; 
• Pre-calculating the value of shares (409A valuation) when options are issued; 
• Evaluating the success of the company and its development dynamics, comparing it with other market players;
• elaboration of the development strategy and much more.

Equally useful to venture capitalists and M&A departments at corporations is the valuation of startups in order to:

1. Monitor fluctuations in the value of their portfolio;
2. analyze the prospects for a particular acquisition;
3. use value data to negotiate the purchase of a stake in a startup;
4. sell their stakes in startups (conduct exits).

Specialists at investment banks use startup valuations to effectively support clients with buying, selling and investing issues. Value information is important for industry reporting and attracting new clients.

Finally, the least active category, retail investors (individual nonprofessional market players), require access to public company valuation data to make investment decisions. They include startups that have made IPOs. Such information helps diversify portfolios and balance the allocation of investments. 

Data needed to evaluate a startup

Financial reports. Detailed information on revenues and expenses helps form a forecast of cash flows, profits, and growth rates. Startups with high growth prospects are valued higher in value.

Management experience. The professionalism and experience of the team also affects the estimated value of the business, especially when management has a track record of other successful projects. However, if a startup hangs on one CEO, investors will see this as a risk factor. 

Market conditions. External factors should be considered: the state of the economy and sector, the level of interest rates, average salaries, and competition. For example, a startup that has emerged in an overly popular niche will receive a lower valuation. 

Intangible assets. Reputation, brands, and customer base are not subject to objective valuation, but can significantly affect the final verdict.

Intangible assets. Equipment, real estate, vehicles, and other real-life assets. Their value should be calculated and added to the overall evaluation of the startup. The higher the quality of the tangible assets, the higher the “premium”.

Company size. The larger the company, the higher the revenues tend to be. Multiple staffing reduces the criticality of losing key employees and executives. Also, large companies tend to have more tangible and intangible assets. Therefore, large companies tend to be valued higher than their smaller competitors. 

Competitive Advantage. Unsustainability of competitive advantage or inability to maintain it will immediately affect the startup’s valuation. 

Where to find data for analysis

The valuation of a startup directly depends on the input data. When analyzing your own startup, of course, you already have all the data at your fingertips. But what if you need to analyze someone else’s project? The task is complicated by the fact that there are not many public startups which have gone public. The bulk of venture capital projects are private companies, which are not obliged to disclose their finances. 

So, investors, analysts and entrepreneurs rely on a wide range of sources to uncover a company’s value:

1. Public filings (IPOs, S1s, SEC filings);
2. media information about investments, sales, etc.;;
3. evaluations by other experts;
4. unofficial forecasts of stock returns.

Startup valuation methods

The market value of a startup reflects how market participants and investors value that company. For example, public companies can be valued at a share price. If a startup issued 100,000 public shares at $50, its market capitalization would be $5 million.

However, the value of a public company may go beyond market capitalization. Private companies, on the other hand, require a very different approach. 

We have conventionally divided approaches for valuing startups into two categories: startups that generate income and startups that have not yet reached earnings. 

Methods for profitable startups

The valuation of profitable private companies that have started generating sales is usually done using discounted cash flow (DCF), multiples or net cost of capital. These methods can either be used alone or combined to cross-check results.

1. Discounted cash flow

2. Valuation with multipliers

3. The method based on the net asset value

Methods for startups with no income

It is more difficult to evaluate startups that do not generate revenue. They do not have profit margins, so you have to use other parameters, such as traction, merit of founders, and market trends.

4. Berkus method

5. Risk factor summation method

6. Scoring method

7. Venture Capital Method

Which approach should be chosen to evaluate a startup?

In addition to the seven methods mentioned above, there are others, but they can all lead to different evaluations of the same startup. So it makes sense for funders to carefully select a methodology according to their goals. For example, if you are going to sell a company, a higher valuation is beneficial to you. And vice versa: if acquiring a business, you would definitely prefer a lower one.

Keep in mind: established traditions in some industries may influence which methodology is used to value startups. Similar businesses are usually evaluated in the same way, too. Another thing to consider is the unique characteristics of the startup’s products and technology. Innovative businesses are more likely to prefer a method that focuses on future growth potential rather than current assets.

Finally, you can always use several methods to value your company and settle on an arithmetic average or arm yourself with a range of them when negotiating. 

Conclusions

On which option to stop? The need to choose the most appropriate methodology also brings discord to the final estimates: different experts may come to different conclusions regarding the value of the business.

In addition, in reality, everything depends on the plans that the valuation is pursuing, and the realities of the market. Most often, information on the cost of existing similar projects is collected, and their cost is used as a basis for own pricing. The next step is refinement, using the methodologies mentioned in the material.

The evaluation of startups takes into account many factors, both objective and subjective. The most correct results require a broad layer of data about the company, and their absence complicates the process. It is important to remember: the valuation of a company is dynamic, as it changes depending on a number of circumstances.