Startup Valuation: Methods to value a Startup
Created on 05 Mar 2021
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Updated on 26 Jul 2022
From Zomato to Bharat Pe, the startup culture which knocked on India's door a few years ago seems to have settled well in the country. The last few years saw an upward trajectory in the number of startups coming up in India. And a lot of them travelled a journey from being a small business to a unicorn to now being established as a threat to numerous big industry sharks in the market.
These startups come with a valuation tag. Every startup, irrespective of how great their idea is or how great the market is for the same, is judged upon some certain metrics, the most important of them being their valuation. While their valuation crosses millions sometimes, we may not be knowing the methods which are utilized by the startup to arrive at that value.
So why know a thing about them today!
Startups can utilize several methods to arrive at their valuation. Now you might be wondering, why would a startup need to do all this? The answer is simple "money".
Every startup would require enormous seed capital and funds to fuel the different stages of their growth. And just the greatness of their idea or the authenticity of their success won't lure out the investors. Though all these factors are important, it is ultimately the valuation of a particular startup that attracts the investors and venture capitalists to invest in them.
Hence, it becomes crucial to rightly predict their worth because anything less or more would leave a serious dent in their path of growth.
Having understood the significance of evaluating a startup, let's jump into the details of it.
First on our list will be the Berkus approach, which is otherwise known as the "stage development method or the development stage valuation method". It was first put forth by a US-based Venture Capitalist, David Berkus, to calculate the valuation of the startups. This method utilizes five key metrics for making the right calculation regarding the worth of the startup. Those metrics include:
1. Basic Value – This is essentially arrived at by valuing the idea on which the entire business will be running. A sound idea that has enormous potential for growth plays a key role in calculating this quantitative measure. A company can add up to $ 500,000 to its worth when calculating this factor.
2. Technology – Here, the focus ultimately lays on the prototype the company or startup holds. While determining the valuation of the startup under this head, the company should see how efficient it is, how well it uses technology to meet its end needs, etc. $500,000 will be the maximum limit to value a startup.
3. Execution – No matter how big your ideas or dreams are, the quality of management can either be a deal maker or breaker. Hence, under this head, you will be allotted a maximum of $500,000 to the type of management and how effective they are in executing the tasks.
4. Strategic relationships in the core market – This is majorly concerned with the market associated with product or service, risks, etc. The limit remains the same for this head as well.
5. Production and consequent sales – How you will be reaching the end customers and how you are planning to deal with the supply chain answers the valuation question in this stage.
Though the Berkus Method is seen as an important method utilized by many startups, it fails to take into consideration a lot of other aspects of startup life. However, for a startup that is in the early stage of its life with no revenue generation, this might be an ideal way to arrive at the valuation.
This is another popular method. Through this, a startup owner would calculate the expenses which will be incurred to recreate the entire business. For this, all the physical assets, spending for research and development and any other expenses that have been incurred in the process will be included. Though this seems to be a good way of calculating the startups' valuation, it's not free from drawbacks. Some of them are as follows:
1. It does not take into account the valuation of intangible assets. Certain aspects like the brand name, goodwill plays a crucial role in any business. They might make a business great or simply destroy it. Hence ignoring the qualitative value of the same will make your valuation figure misleading.
2. Future potential is an important parameter to any business, big or small. Thus, avoiding them in arriving at your valuation might act as a hindrance in arriving at the right figure.
3. Other key factors, like customer engagement, are also excluded.
Discounted Cash Flow Method
Startups and risk go hand in hand. When compared to a normal or running business, startups are riskier. That being said, for the amount of risk you take, you will expect the same level of reward. The same idea is behind this method.
Here, you will be required to calculate the future discounted cash flows which your business will be getting throughout the period or estimated period. To that, you will have to apply a discount rate or ROI to arrive at the right value.
Now, if you are getting a higher discount rate, that means your returns from the business should also be higher, and so, your valuation increases. There are three main scenarios under this method that will offer insights into your valuation. They are:
1. Your business performing exactly the way you expected.
2. Business performance being poor than what was expected.
3. Business performance is better than what was expected.
Here, the sum of discounted values will be your valuation. This method depends on both future and historical data to arrive at the solution.
Venture Capital Method
This is another popular method utilized by a lot of venture capital firms. To calculate the value of the firm, you will need to derive the terminal value or the value at which you will be selling the business and the Return On Investment. Plugging in these values to the formulas will help you arrive at the solution.
The formulas for the same are as follows:
ROI = Terminal Value / Post Money Valuation
Pre-money Valuation = Post-money Valuation – Invested Capital
The Bottom Line
Apart from the above-mentioned methods, there are many other methods that can be used to measure the valuation of the business. These methods include the risk factor summation method, book value method, etc.
However, the above mentioned are the most prominently used and are popular among Indian startups.
The valuation of a startup is significant in establishing it in the competitive market. Hence, it also becomes important for the common people to know how these small companies are valued at such high amounts.
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