Common valuation methods

Valuing a startup at an early stage is much different from valuing established companies. Since early-stage startups often lack significant financial history or stable revenue, investors focus on factors that reflect future potential rather than immediate returns.

Here are several common valuation methods used by investors in the early stages:

Comparable company analysis

Investors frequently use a comparable company analysis (or "comps") to value startups. This method involves comparing the startup to similar companies that have recently raised funding. Investors can estimate the value of a startup by analyzing the valuation multiples applied to similar businesses.

For example, suppose seed-stage startups in the same sector are valued at 10-15x revenue. In that case, an investor might apply that multiple to the startup’s top-line revenue, adjusting for differences in sector, customer type, and technology.

Scorecard method

The scorecard method is often used at the earliest stages, such as during seed funding. It involves comparing a startup to others that have received funding but focusing on specific factors that influence a company’s potential.

These factors might include:

• The strength of the team
• The size of the opportunity
• The product’s uniqueness
• The competitive environment

A score is assigned to each factor, and these scores are then multiplied by the average pre-money valuation of comparable companies to derive the startup's valuation.

Reverse engineering ownership requirements

Venture capital firms typically have specific investment ownership requirements, often detailed in their limited partner documents. An investor may calculate a startup’s average valuation by considering the funding needed and the ownership stake they wish to acquire.

For example, if an investor needs a 10% stake in exchange for a $1M investment, the startup’s post-money valuation would be $10M.

Exit multiple approach

Many investors, especially venture capitalists, consider exit multiples when valuing startups. They consider how much they can potentially make from their investment when the startup is sold or goes public.

This method looks at the return they expect based on the entry valuation and the anticipated exit market value. Angel investors typically target high multiples (e.g., 100x) for their investments.

However, they are also mindful that an entry valuation that is too high can make a successful exit less likely.

Berkus method

The Berkus method is particularly useful for pre-revenue startups. It assigns dollar values to key factors, such as:

• The quality of the idea
• The management team
• The product prototype

This method caps pre-revenue valuations at $2 million, making it ideal for startups with limited data but solid potential.

Comparable transactions method

In the comparable transactions method, a startup’s valuation is based on the sale prices of similar businesses in the same industry. This is often used when historical acquisitions or seed rounds are available for comparison.

For example, if a similar company was acquired for $24 million, the startup could be valued based on similar multiples or metrics, such as users or revenue.

Cost-to-duplicate approach

This method calculates the cost to duplicate the startup by assessing the cost of its tangible assets, including research and development and prototype creation. It’s useful for valuing startups that are still in the early stages of product development.

However, it doesn’t fully capture a company’s potential, especially if it’s generating revenue or has strong customer engagement.

Risk factor summation method

The risk factor summation method adjusts a base valuation by adding or subtracting value based on specific risks that might affect the startup.

For example, suppose there are competition, technology, or market uncertainty risks. In that case, the valuation may be adjusted up or down in increments of $250,000, depending on the level of risk assessed.

Discounted cash flow (DCF) method

The Discounted Cash Flow (DCF) method is more common for mature startups with predictable revenue streams. It involves projecting future cash flows and discounting them back to their present value, adjusting for the risk associated with the investment.

However, this method is rarely used at the seed stage because early-stage startups typically don’t have consistent cash flow.

Venture capital method

The venture capital method is widely used by VC firms. It calculates the post-money valuation based on the expected exit value and the desired return on investment (ROI). The method relies on estimated revenue multiples and price-to-earnings ratios for the industry.

The expected exit value is used to determine the post-money valuation, from which the investment amount is subtracted to determine the pre-money valuation.

Book value method

The book value method is a simple asset-based approach that calculates a startup’s net worth by subtracting its liabilities from its total assets. This method is more commonly used for companies with physical assets but is rarely applied in early-stage startups, especially those in the technology sector.

Evaluating the team

When investors assess a startup, they often begin by evaluating the experience and skills of the founders and early team members. The composition of the team is crucial, especially in the early stages when there isn’t much historical performance to rely on. Here’s what potential investors typically look for:

Founder experience

Investors want to know if the founders have had success in the past. Have they started and sold companies before? A founder with a proven track record can be more attractive because their experience suggests they can handle the challenges of building a business model.

Team chemistry

Investors also pay attention to how well the team members work together. If the team has collaborated with previous companies, it’s a good sign. It shows they can work effectively as a group and understand each other’s strengths.

Domain expertise

The team needs to know the industry they’re working in. Investors look for teams that have deep expertise and understand the problems they are trying to solve. If the team has the right skills and knowledge, they are more likely to succeed in executing their plan.

Market gap analysis

Investors who assess a startup often look at its ability to fill a market gap. A market gap exists when existing solutions do not fully meet a demand for a product or service. Companies can position themselves to fill that need and grow by identifying such gaps.

Two key metrics that investors use to assess a company's potential to fill a market gap are:

Total addressable market (TAM)

TAM represents the maximum possible revenue a company could generate if every potential customer base in the market purchased its product. It gives an idea of the overall size of the market opportunity, but it’s not a realistic target since no company can capture the entire market.

TAM is useful for understanding how big the opportunity could be if the company succeeded in reaching all customers. To calculate TAM, investors might use different approaches:

• Top-down approach: This method uses industry data and market reports to estimate the market size.
• Bottom-up approach: This method looks at the number of potential customers and multiplies it by the average revenue per customer.
• Value theory approach: This method estimates the market size based on how much customers are willing to pay for the value they get from the product.

Service obtainable market (SOM)

SOM, on the other hand, represents the portion of the market that your company can realistically serve. It is the part of the market that is within your reach based on your current sales and resources. SOM becomes relevant once your product is in the market and you have customers.

To calculate SOM, investors look at your market share (the percentage of the market you currently serve) and estimate how that share might grow.

For example, if you captured 58% of your target market last year, and the market has grown this year, your SOM for the next year will increase based on that market share.

How investors use TAM and SOM

Investors use TAM to assess the overall potential of the market and SOM to understand how much of that potential a startup can realistically capture.

A large TAM suggests there’s a significant opportunity, while a growing SOM shows that the company is gaining traction in its market.

Together, TAM and SOM help investors determine whether a startup has the potential to grow and fill the identified market gap.

Financials & traction

The current balance sheet provides a snapshot of assets, liabilities, and equity, helping you assess the company’s present financial health. Meanwhile, a projected balance sheet estimates future financial positions based on expected activities, offering insights into future growth potential and financial strategy.

These balance sheets directly contribute to company valuation models by providing data for key calculations like net asset value and debt-to-equity ratios. They also help quantify future financial performance, clearly showing expected profitability and stability. For instance:

• Assets like inventory and property help estimate the company’s operational capacity.
• Liabilities, such as loans and payables, indicate the level of financial obligations.
• Equity shows how much value the company retains for stakeholders.

Projected revenue and expenses for later funding rounds

Investors often look at your projected revenue (anticipated income) and projected business expenses (estimated costs) to gauge the company’s potential. These projections are typically linked to the income statement and reflected in the balance sheet. For example:

• Revenue growth affects assets like cash and accounts receivable.
• Expenses influence liabilities like accounts payable and accrued costs.

Reviewing these figures allows investors to determine whether your financial plans align with your business goals. Consistent revenue growth and well-managed expenses signal financial stability, making your company attractive for future funding rounds.

Wrap up

A company’s value is assessed through various financial metrics, including current and projected balance sheets, revenue, expenses, and equity. These indicators reveal financial health, growth rate, and stability.

For entrepreneurs, presenting detailed and realistic financial projections, maintaining strong credit, and showcasing a strategic funding mix can make a compelling case for investors.

Ready to take control of your finances and explore funding opportunities? Schedule time with a Rho finance expert and take the next step toward financial success.

Pia Mikhael is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.

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