Whenever we talk to founders, the question of valuation tends to come up. In this article, we’ll dive into some of the methods for calculating startup valuations.
Large, established companies are valued using methods like discounted cash flow, comparable company analysis, and precedent transactions analysis. But for a young startup, the data required for these valuation methods are often inaccurate or nonexistent. So, what methods are used to value a startup, and how do they work?
In this article, we’ll cover three basic valuation methods for companies that haven’t yet generated significant cash flow, or are unique enough to lack comparable companies or precedent transactions to draw conclusions from. These three valuation methods are: 1) the venture capital method, 2) the Berkus method, and 3) the Risk Factor Summation method.
Let’s dive straight into them!
The Venture Capital Method
This method revolves around the equation:
Post-money Valuation = Terminal Value Anticipated Return on Investment
The terminal value is the anticipated selling price for the company at some point in the future. This selling price can be determined by the expected revenues and costs in the year of the sale, known as the harvest year. For example, if a company is expected to earn $3M in profit during the harvest year, we can determine the terminal value by using an extrapolated P/E ratio. In our case, if our P/E ratio was 15x, then our company is estimated to be worth $45M. Return on investment is the basic formula: (Money gained from investment – cost of investment) / (cost of investment)
The Berkus Method
One hard truth is: fewer than one in a thousand startups meet or exceed their projected revenues in planned periods. The Berkus method seeks to value aspects of the entrepreneur or management team that may increase the chances of success. These risks can be broken down into five major components best explained in a chart:
|If Exists:||Additional value added to Company X|
|Sound Idea (basic value)||$1/2 million|
|Prototype (reduced technology risk)||$1/2 million|
|Quality Management Team (reduced execution risk)||$1/2 million|
|Strategic relationships (reduced market risk)||$1/2 million|
|Product Rollout or Sales (reduced production risk)||$1/2 million|
The Risk Factor Summation Method
Similar to the Berkus method, the Risk Factor Summation method seeks to add value to the number of risks that may reduce the chances of a startup becoming successful. These risks are categorized into twelve factors:
- Management risk
- State of the business
- Legislation/political risk
- Manufacturing risk
- Sales & marketing risk
- Funding/capital raising risk
- Competition Risk
- Technology risk
- Litigation risk
- International Risk
- Reputation risk
- Potential lucrative exit
Each of these factors is assessed and given a score:
- +2: very positive for growing the company and successful exit
- + 1: positive
- 0: neutral
- -1: negative for growing the company and successful exit
- -2: very negative
Summing all of the scores given to each factor, an investor can guesstimate what the chances a startup has in succeeding. The higher the score, the higher the valuation.
It is important to know that valuations are an estimate. That is, there is no one number that a company is worth. A company is only worth as much as someone is willing to pay for it – gauge how much a potential investor seems to want to invest when negotiating valuations.
We know this can be a difficult process to get familiarized with, and we are here to help startups like yourself with things like this.