Are you afraid of losing money and looking like a fool for making a bad investment? The answer is almost universally yes for every startup’s potential investors.
Fear causes an investor to second guess a sound opportunity staring them right in the face.
The best way to overcome investor fear is knowledge. The knowledge that the startup is valuable and will yield a solid return.
The first and best piece of knowledge is an accurate startup value. Let’s get familiar with the different methods of value calculations. We’ll define how they work and when you should use each one.
How to Value a Startup
There are many ways to calculate the value, but no magic number will meet every investor’s needs. The calculations break down into two major categories:
- Pre-money valuation
- Post-money valuation
Calculations are broken down based on when the payment happens. Usually it’s before and after the current rounds of funding.
With this type of valuation, an investor estimates how much the company is worth right now. It’s an indicator of market confidence in the startup’s potential. It’s not necessary for even a single sale to be made.
This type of assessment can be more difficult to calculate because it depends on where the company is in its stage of development. Such as:
- Is it pre-revenue, meaning it hasn’t made a single sale?
- At what point does the company plan to move from pre-revenue to generating revenue?
- Does the company’s business model contain pre-revenue sales projections?
- Or if the company is past the pre-revenue stage, will the initial investments go entirely towards capital purchases?
These are some of the questions that factor into the value calculation.
What Is Pre-Money Valuation?
This calculation is one of the two startup valuation methods used before the investor commits funds. It sounds intuitive. But it’s necessary to make this distinction for accounting purposes. For example:
Let’s say a startup is worth $10 million. An investor decides to invest $1 million in exchange for 100 shares of stock. The company value before the investment is $10 million and the post-money value is $11 million.
To lower risk, investors will put money into a startup over later rounds of investing instead of all at once. This invest-as-you-go model is common. The startup gets the funds to grow and the investor lowers potential loss if the startup fails.
Pre-Money Valuation Formulas
Every startup is different. So, calculating the startup’s value is not a one-size-fits-all process. Financial experts developed different types of startup valuation methods. Each one focuses on a different financial perspective.
A savvy venture capital investor will use many methods to calculate value. Then they decide to invest in an early-stage company based on an averaged amount.
The Discounted Cash Flow (DCF) Valuation Method
The Discounted Cash Flow method measures the future revenue potential of a startup. It generates a value based on a large number of detailed assumptions about the startup’s business model. It then calculates revenue over a set period of years.
DCF works best as a type of “sanity check.” Combine it with other methods to ensure the average value falls within an acceptable range of accuracy.
The Berkus Method
The Berkus Method was developed as a way to calculate the startup valuation without unreliable assumptions. In David Berkus’s own words:
It’s best to use this method if the risk factors are known. Also, it works if the return on investment for the startup is unknowable due to too many assumptions.
|If Exists:||Add to Company Value up to:|
|Unique Selling Proposition (USP)||$500,000|
|Quality Controls in Place||$500,000|
|Partner Agreements Pre-Revenue||$500,000|
Value factors for the Berkus Method
Scorecard Valuation Methodology
This method answers one basic question when it comes to startup valuation methods. “How valuable is this startup compared to similar companies?”
The Risk Factor Summation Method
The Risk Factor Summation Method is a combination of the Berkus Method and the Scorecard Valuation Methodology. It measures startup valuation by comparing the company with other companies. The comparison is used to develop a baseline. It then adjusts the value based on a list of 12 risk factors.
Like the DCF, it’s best to use this method with other methodologies to develop an average score.
Venture Capital Method
The Venture Capital Method takes a finite term approach to the valuation method. The investor assumes an exit term, say 5 or 7 years, from the point of investment. It then back-calculates the return on investment for that period.
This is one of the preferred startup valuation methods. An investor can set the exit strategy on milestones. An example milestone would be reaching a specific dollar amount in sales or percentage of market share.
Like the Scorecard Valuation Methodology, the Comparables Method calculates a value by comparing the startup to similar companies. Unlike the Berkus Method, the baseline is adjusted by a series of ratio values. The ratios include price-to-earnings ratio (P/E), price-to-sales ratio (P/S), and enterprise value-to-earnings before interest, rather than flat dollar adjustments.
The Comparables Method is simpler to calculate. It relies on fewer assumptions than the discounted cash flow method. But accuracy is more dependent on the accuracy of the market value of the peer group used in the baseline.
The Cost-to-Duplicate Method looks at the cost of starting over from scratch in another location or industry. This method can help investors determine soundness very quickly. If the company can be reproduced cheaper or better in another location, it’s not a good investment.
This is a very rough calculation. It doesn’t take mitigating factors into account like tax laws in alternative locations. It’s quick but very prone to error.
Pre-Money Valuation Calculator
The methodologies listed so far are subtly different. But most have strong similarities. This makes the prospect of calculating value confusing.
Fortunately, Quantic has published a free template to help.
Post-money valuation is a measure of the startup’s value after the current funding round is complete. This gives investors a view into how much other investors are willing to support the startup. It’s a picture of the willingness of others to financially back its chance of success.
What Is Post-Money Valuation?
Post-Money Valuation is a company’s value after it receives money from the current round of funding. This value is an indicator of how many shares an investor will own as a function of the amount of money invested.
If a startup only has one investor, that investor will receive 100% of the available shares. If there are many investors, there’s strong confidence in the company. But this also reduces the percentage of available shares that can go to a single investor.
Post-Money Valuation Formulas
As with the other value calculations, there are several to calculate post-money. It’s best to base investing decisions on an average of the methods used.
Book Value Method
The Book Value Method looks at all the tangible assets of a startup after a funding round. It then deducts the intangible assets to derive a net value. It’s a strong indicator of the company’s value on a Balance Sheet. This calculation only works once the investments into the company are complete.
It’s best to use this method if a significant part of the company’s value relies on tangible assets. If a startup relies on patents and copyrights, avoid using this method.
Post-Money Valuation Calculator
Again, it can be confusing to sort through the myriad of methodologies – both before and after funding. To help, Quantic has released a free template to assess the post-money value of a company. It’s a useful tool for investors to make informed decisions.
Note; ideally, we want to have an opt-in here in exchange for the formula calculator.
Valuation Cap Calculation
Here’s why it’s so valuable. “It is intended to ensure that an investor does not miss out on significant appreciation of a company between the time of the sale of convertible notes and the qualified financing.”
No investor wants to miss out on the benefits of explosive growth. The valuation cap makes the investment more lucrative when unexpected growth occurs.
Startup Valuation Spreadsheet Templates
In the sections above, we’ve provided a free downloadable template that calculates startup value. It’s specifically based on the most common methods used today. But the template also contains a section for Scenario Analysis. This is useful to help compare the results of multiple methods to calculate the best average.
Note; ideally, we want to have an opt-in here in exchange for the formula calculator.
When it comes to startups, Quantic has helped plenty of students build companies that grow. But its courses on valuation for cash flow and valuation for equity are specifically designed to help startups position themselves to look attractive for investors.