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The Art of Science and Valuation – Part 6

Valuation of Startups

The valuation of a startup can be divided based on the time at which the valuation is done. Suppose the valuation is done before receiving any outside, external financing or investments. In that case, it is called pre-money valuation. However, if the valuation is done after receiving external funding and investments, it is called post-money valuation. Pre- Revenue Valuation is done when the business is yet to have revenue. Post- Revenue Valuation is done once the company starts earning revenues. Some of the methods of startup valuation are as follows.

There are 8 methods which can be used for startup valuations

Methods of Startup Valuation

Berkus Method

Berkus' Method for the valuation of startups is explicitly used for pre-revenue startups. This was founded by a venture capitalist named Dave Berkus. The basic idea of this

The theory is to assign dollar amounts of up to $500,000 for five fundamental success metrics of the startups. This method helps to arrive at a valuation for the startup without considering the potential future revenues which such startups might not meet. This has a maximum cap on valuations of up to $ 2 Million for pre-revenue startups and $2.5 Million for post-revenue startups.

Scorecard Valuation Method

Scorecard Valuation Model is a startup valuation technique that is used to value a pre-revenue startup. This works by using the average pre-money valuation of comparable startups and then providing scores for the various qualities of the business. The qualities taken into consideration in this method are as follows:

  1. Team strength – 0-30%

  2. Size of the opportunity – 0-25%

  3. Product or service – 0-15%

  4. Competitive environment: 0-10%

  5. Marketing, sales channels, and partnerships: 0-10%

  6. Need for additional investment: 0-5%

  7. Other: 0-5%

Each of these qualities should be scored with a percentage.

100% means it is on par

< 100% is below average score

> 100% it is above average

Once the scores are done, the same is multiplied with the assigned weights given against each quality. The total sum of all the weighted scoring factors should be

multiplied by the average valuation arrived from comparable to arrive at the business value.

Cost-to-Duplicate Approach

Cost-to duplicate approach is similar to that of the reproduction cost method of assets approach. This method considers how much it would cost to recreate the startup with deductions of the value of intangible assets. However, this method does not capture the entire value of the company. It includes the fair market value of all the physical assets and the costs associated with R&D, product prototypes, patents, etc.

Venture Capital Method

This method is also most suitable for pre-revenue valuation and is most commonly used by venture capitalists. In this method, the startup’s value is arrived at by first calculating the terminal value of the business after the VC Firm invests in the startup. This is done with the help of revenue multiples obtained from the industry or P/E ratio. Once this is done, the anticipated Return on Investment is to be identified. Once that is done, the post-money valuation can be arrived at by using the formula.

Post Money Valuation = Terminal Value/ Return on Investment Expected

Once the post-money valuation is identified, the amount being invested should be subtracted from the post-money valuation to arrive at the pre-money valuation.

Pre-Money Valuation = Post-Money Valuation – Amount Invested

Book Value Method

This method of valuation of a startup gives an asset-based valuation. This method takes into consideration the total value of a company’s assets minus its liabilities and, in the end, provides us with a valuation that is equal to its net worth.

Risk Factor Summation Method

This method adds to the valuation arrived at by any of the methods mentioned above. Once the valuation is done, based on the risks which affect the startup being valued, the valuation needs to be increased or decreased in multiples of $250,000. The startup risks may be numerous and include risks such as management, litigation, reputation, competition, etc.

A Low risk (++) factor is given a +$500,000

A high risk (–) factor is given a -$500,000

DCF Method

The DCF method can also be used in the valuation of startups. The rules and methods applied for the matured companies DCF also apply to startups. However, there might be different discount rates and forecasts based on the startup. A comprehensive method of DCF Valuation for startups is the First Chicago Method. This method takes into account three scenarios: an Optimistic scenario, a Pessimistic Scenario, and a Normal Scenario.

Comparable Transactions Method

The comparable Transaction method makes use of information and multiples from comparable precedent transactions. It can make use of different revenue multiples and factor the same for adjustments for differences in characteristics. This is one of the most widely used methods.

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