Determining a startup’s value is notoriously difficult.
Established companies have a straightforward method for valuation — EBITDA. This stands for “earnings before interest, taxes depreciation, and amortization.”
Basically, steady revenue over a few years gives an objective foundation to base valuation on.
Startups, on the other hand, haven’t been around long enough for EBITDA to work.
Startup valuation is based heavily on future projections. Without values for annual net profit, interest, or taxes, founders and investors are left to create their own subjective valuation.
As an angel investor, your ROI depends on valuation. Finding high-potential startups with low valuations can mean huge returns on exit, whereas high or inaccurate valuations can be a recipe for failure.
How Startups Decide on Valuation
There are many ways to establish the value of a startup. These range from fast and loose checklists to meticulous evaluations.
The method a founder or investor uses to decide on a valuation depends on the type of startup, its stage, and its industry.
Here are some of the most common and effective methods.
1. The Venture Capital Method
This method is made from the perspective of an investor. You calculate the expected value of the company after a set number of years. This method is designed specifically for pre-revenue companies like early-stage startups.
The Venture Capital Method of valuation allows investors to see how much they should invest today based on what the company will be worth in the future.
Being an investor-centric method, the valuation depends on the profitability of investment more than anything else.
2. The Berkus Method
According to legendary angel investor Dave Berkus, the Berkus Method, “assigns a number, a financial valuation, to each major element of risk faced by all young companies — after crediting the entrepreneur some basic value for the quality and potential of the idea itself.”
Valuation is assigned to several areas of the startup. Each component corresponds to a risk-lowering, value-adding opportunity.
Here’s how it works:
|Sound Idea||Basic Value|
|Prototype||Reduces Technology Risk|
|Quality Management Team||Reduces Execution Risk|
|Strategic Relationships||Reduces Market Risk|
|Product Rollout or Sales||Reduces Production Risk|
You assign a cash-value to each component based on how strong it is.
The maximum dollar amount per component is $500,000 for pre-money valuation. This leads to a total maximum valuation of $2,500,000 for a “perfect” startup.
3. Scorecard Valuation Method
The Scorecard Valuation Method is the most comparative method. This method widens the perspective of valuation to other startups in the same field and region.
By comparing a startup to other similar ones in your area, you can measure the startup against the value and status of the most similar startups on the market.
You then can adjust the comparative valuation based on the strength of the management team, competition, market size, etc.
Each of these components is assigned a percentage that adds to your initial comparative valuation.
4. The Cost-to-Duplicate Method
This method draws up a valuation by estimating how much it would cost to duplicate the startup as it stands.
- For a technology startup, you could look at the cost of research and development plus the cost to produce a prototype.
- For a software company, you could look at how much it cost to have a team of programmers build the code again.
- For any company, you can look at its physical assets — deciding how valuable their inventory, infrastructure, and other tangible assets are.
Cost to Duplicate is a nice starting point for startup valuations. It is one of the most objective methods of early-stage valuation and can set the stage for more subjective methods to follow.
5. Discounted Cash Flow Method
Discounted Cash Flow involves projecting how much cash flow the startup will produce in the future.
You figure out the cash-flow potential, decide how quickly the investment will be returned, and then establish how much that cash flow is worth.
The value of the projection is then discounted to compensate for risk factors. That final discounted number is chosen as the startup’s valuation.
6. SaaS Napkin Method
The SaaS Napkin Method was made by entrepreneur and angel investor, Christoph Janz.
In 2016, Janz asked himself what it takes to raise capital in SaaS. He wanted an answer that could fit on the back of a napkin. And so, the SaaS Napkin was born.
Now the underground standard for all SaaS founders — this magic napkin lays out SaaS funding and valuation perfectly.
The SaaS Napkin shows a chart that breaks down Seed, Series A, and Series B funding.
Different aspects of the startup like the team, product, marketing, round size, and valuation are laid out across the different stages of funding. This serves as a foundation for establishing value and a roadmap for SaaS companies looking for funding.
How Valuation Affects Your Investment
The reason valuation — and getting a low valuation — is so important, is simply that you can get more for less.
While it may seem reasonable to try to eliminate risk by investing in a more developed startup, it’s important to know that more developed startups typically have higher valuations.
This means your dollar gets you a smaller slice of the pie and that future growth will yield you less return.
On the other hand, an extremely young company will generally have a much lower valuation and higher risk.
This translates to a larger share of the company for you, and because you are getting in on the ground floor, the potential for the highest possible return.