Did you know that no more than 40% of startups actually turn a profit? If you have a business idea that you want to take to the bank, there are some things you’ll need to consider first.
To gain funding for your new business, you need to calculate startup valuation. Keep reading to learn what this is and the different calculation methods.
What Is Startup Valuation?
Startup valuation is a calculation that determines the value of a startup company. There are different startup valuation methods that can help new companies in the pre-revenue stage.
If you expect to gain funding to bring your business ideas to life, you’ll want a low valuation that promises a high return on investment (ROI). During your pitch to investors, this will be an important point to make.
An already established mature business will have hard facts to go off of to calculate the value of its business. This is not the case with startups.
Valuation methods for startups won’t detail taxes, amortization, and profit, but you can consider other key factors in the process.
Pre-Revenue Startup Valuation Key Factors
Early-stage startups are often valued in the middle. This means investors pay more than they want to and business founders don’t get quite as much value as they initially thought.
One of the main indications of the value of a startup is traction. Traction proves that the business concept is financially sound.
You’ll need to show that you already have customers and that you can continue to attract high-value customers with affordable marketing tactics.
Proving that your business can grow on a small budget is beneficial for investors looking for growth opportunities.
Investors also want to make sure the team responsible for the business idea is destined for success. Investors will consider the following:
- Proven experience
- Diverse skills
- Commitment
If your company is reviewed with the valuation-by-stage method, you can earn millions in investments if you have a Minimum Viable Product (MVP). A working prototype is helpful in valuing your business.
Lastly, supply and demand and high margins are key factors for valuing a startup business. The demand in your industry needs to be high and your profit margins shouldn’t be low.
Now, let’s get into the different startup valuation methods.
Berkus Method
One common startup valuation method is the Berkus Methos. Using this valuation calculation involves these critical aspects:
- Concept
- Prototype
- Quality management
- Connections
- Launch plan
The highest possible valuation is $2.5 million as each aspect is given a rating of no more than $500,000. This simple estimation is commonly used for tech startups that need to gauge value.
The downside is that it doesn’t take the market into account which won’t provide the scope every investor desires to see.
Scorecard Valuation Method
The Scorecard Valuation Method is popular among startups and is often used by angel investors. You might have heard of this method referred to as the Bill Payne valuation method.
Scorecard Valuation works by comparing your startup to startups that are already funded.
Determine the average valuation for pre-revenue startups in the same market as yours. Doing this for multiple startups can help you determine how your business idea stacks up against that competition.
Compare these factors:
- Strength of the management team
- Opportunity size
- Technology/product
- Competitive environment
- Marketing/partnerships/sales channels
You’ll also want to take into account the need for additional investments. Rank all of these factors to see how you compare.
Venture Capital (VC) Method
Bill Sahlman of The Harvard Business School made the Venture Capital Method popular. This is a two-step process requiring pre-money valuation formulas.
You’ll first need to calculate the terminal value of the business during the year that it starts. Secondly, you’ll go backward tracking the expected ROI and investment amount. This will allow you to calculate the pre-money valuation.
To run the calculation, you’ll need these figures:
- Industry P/E ratio
- Projected profit margin in the harvest year
- Projected revenue in the harvest year
If you don’t have these numbers, research industry averages online. With the figures, complete this calculation:
- Terminal Value = Projected revenue x Projected margin x P/E
Projected revenue x projected margin will give you a figure for earnings.
For the second step, you need the investment amount and the required return on investment. Once you have those figures, complete this calculation:
- Pre-Money Valuation = Terminal value/ROI – Investment amount
This method is a little more complicated than others because it involves calculations rather than just comparisons. However, showing investors the numbers can be helpful in receiving additional funding.
Risk Factor Summation Method
The Risk Factor Summation Method is a combination of the Berkus Method and the Scorecard Method. This form of valuation provides founders with a detailed estimation that focuses on the risks of investing in a business startup.
Investors will appreciate seeing this method because it takes these risks into account:
- Stage of the business
- Technology risk
- Competition risk
- Management
- Funding/capital risk
- Sales and marketing risk
- Manufacturing risk
Each risk area is given a score. The scoring for scaling the startup and carrying out a successful exit looks like this:
- -2: Very negative (-$500,000)
- -1: negative (-$250,000)
- 0: neutral ($0)
- +1: positive (+$250,000)
- +2: very positive (+$500,000)
This technique is best for examining the risks that must be managed in order to make a successful exit. Pair this method with the Scorecard Method to provide a complete overview of valuation for a startup.
Managing Startup Costs at the Pre-Revenue Stage
The pre-revenue stage is rough for any business just starting out. To manage ongoing startup costs, you might need to reach out to additional investors.
During your pitch, it’s best to use one or more startup valuation methods to encourage investors to join your cause. Use this guide to start making calculations.
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