Valuation is neither a science nor an art. It is a craft. A crucial aspect of any startup’s path to accelerated growth. However, it can be a tricky process, especially for entrepreneurs who are not finance-savvy.
Back in 1999, companies began adding “.com” to their names as it positioned them as innovative, high-growth investment opportunities, making their valuations higher. After the burst of the dot-com bubble, those that survived removed the “.com” from their name.
Valuation requires strong financial knowledge, but you’ll be surprised how the value of companies can change with their narrative.
A startup with a great vision and strong storytelling can be valued far higher than a similar startup with better financials.
In this blog, we will explore different valuation methodologies and how they work best through the different stages of funding and growth.
Pre-Revenue Methodologies
Rule of Thumb
Some angel investors and venture capitalists use a “rule of thumb” value to develop a range of startup values quickly. The investors typically set the values, and they depend on the startup’s stage of development. Simply put, the further the startup has progressed, the lower the investor’s risk and the higher its value. Examples of stages of development include:
A startup with just an idea.
A startup with a prototype and a capable team.
A startup with a minimum viable product (MVP) and early adopters.
Scorecard Valuation Method
This method involves assigning a score to different aspects of the startup, such as the management team, the size of the market, and the stage of development. The scores are then used to calculate a pre-money valuation.
Berkus Method
Instead of assigning scores to aspects within the startup, this method values milestones the startup has achieved, such as completing a prototype or securing a key partnership. The values are then added up to calculate a pre-money valuation.
Risk Factor Summation (RFS)
This method involves assigning a score to different risk factors associated with the startup, such as competition and regulatory risks. The scores are then used to calculate a pre-money valuation.
You should often run all or several of these methodologies for your company, then evaluate which makes more sense from a storytelling perspective. You will be tempted to give your startup the highest valuation, but this can be a double-edged sword as you must meet the growth expectations to stay at a high valuation. Be smart and realistic, otherwise, you’ll pay the consequences later.
Post-Revenue Methodologies
Discounted Cash Flow (DCF)
This method involves estimating the future cash flows of the startup and discounting them back to their present value. To do this, you’ll need to:
Make assumptions about the future and be able to defend them.
Forecast your P&L for at least 5 years.
Estimate a cost of capital (WACC).
Estimate reinvestments.
Create different scenarios around your growth strategies.
Do not use Excel as a magic wand. BE REALISTIC and set limitations to growth.
Comparable Multiple
This method involves looking at the valuations of similar companies in the same industry and geographic location and using them as a benchmark for the startup’s valuation. It can be challenging to find similar companies, as many startups develop unique solutions. Think about the fundamentals for your business, revenue streams, go-to-market strategy, customer acquisition costs, scalability, and cost structure, and find companies that behave similarly.
Revenue-generating startups should always run both methodologies. DCF will help you understand the intrinsic value of your company and create diverse scenarios. Comparable multiples will help you understand how the market is pricing startups like yours.
Understand the difference between value and price. Value is driven by fundamentals. The market drives price.
A Path Through Stages of Funding/Growth
At Seed Stage, the startup is typically pre-revenue and has not yet achieved any significant milestones. Valuation is, therefore, more of an art than a science. Use the Scorecard Valuation Method and the Berkus Method.
In Series A, you will typically have achieved significant milestones, such as completing a prototype, securing a key partnership, and/or landing your first customers. Valuation is, therefore, more data-driven than at the seed stage. You can use a mix of Scorecard Valuation, Comparable Multiple, and DCF methods to solidify your case.
For Series B and Beyond, your company is well-established and ready to accelerate growth and expansion. In this stage, stick to DCF and Comparable Multiple methods. It will become more relevant to use well-backed assumptions, create a strong narrative, and communicate it properly through storytelling techniques.
The New Era of Valuations
Today, we find ourselves in an era where there are cloud-based platforms that allow you to input some numbers and company details and come up with several valuation methodologies in minutes.
You’ll be surprised to find how much a small variable can double your valuation, but just as easily, your valuation can be torn up by a well-informed investor.
It becomes crucial to understand the variables that drive valuation and how to use them to your advantage.
In this decade, valuations will evolve rapidly with the help of AI. In a few years, you’ll be able to update your valuation with surprising detail every month, maybe every week. It will be important to stay grounded and advised by valuation experts, otherwise, more bubbles shall form and explode.
Written by Roberto Barrera, managing director at SALUS Capital | Strategy.
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