Knowing how to value a startup can be daunting for founders and potential investors. By definition, this is a venture into a new market, so there should be no direct comparison to an existing business.
Startup business owners need a way to determine the value of their company in the pre-revenue stage. The owners or founders want the value to be as high as possible. In contrast, investors want to undervalue the startup so that they will see large returns on their investment.
In determining the value, investors look at the following areas:
- Reputation—If the owner has a proven track record of success, or the product or service has established success then the reputation value is high.
- Prototype—a working prototype of the product will increase the value.
- Customer base—if your startup has an established customer base or can prove that there is a large potential customer base, this lends value.
- Revenues—Revenue streams like charging users makes it easier to value a startup.
- Supply and demand—are you operating in a crowded market place or the sole provider of a certain product or service?
- The temperature of the industry—investors will pay a premium to be part of a booming industry. If the industry is more tepid, investors are harder to find.
All of these factors and more are given consideration when valuing a startup. There are several methods of valuation, and usually, investors want to see an average of multiple methods. The most popular methods are:
- Venture Capital
- First Chicago
- The Book Value
- Valuation by Stage
- Risk Factor Summation
- Scorecard Valuation
Each method uses a separate formulation to determine value. For example, the Venture Capital method uses this formula:
Return on investment (ROI) = Terminal Value/Post-money Valuation
Post-money valuation = Terminal Value/Anticipated ROI
The Scorecard Valuation Method uses the average pre-investment valuation of other startup businesses in the area. It then judges the startup that awaits valuing against a scorecard. So, the formula looks like this:
- Strength of the management team—0-30
- Size of the Opportunity—0-25
- Competitive Environment—0-10
- Marketing/Sales Channels—0-10
- Need for Additional Investments—0-5
Each valuation method has unique strengths and weaknesses, and this is why multiple means of valuation are often employed and an average determined. Some startups may score as extremely risky with a low potential for return on the venture capital method but score well on several other methods.
The industry standard of using multiple methods is advantageous in giving the fairest assessment to each start-up.
The word startup is appearing more and more frequently when discussing businesses. So, what exactly is the difference between a startup and a new business?