As my mother always said, It takes money to make money. But particularly for early-stage startups, it can be difficult to tell investors exactly why and how much they should invest in your company. The valuation tools that established businesses rely on simply aren’t relevant for startups. In a startup’s early stages, founders are still in the process of defining their products, markets, and scales – collecting the data that investors rely on in order to gauge whether a business is bound for success.
In this article, we explain why classic valuation processes don’t work for startups. Instead of relying on standard valuation methods, we offer you a number of guidelines and resources for figuring out exactly how to execute your startup valuation, so that you feel confident when you walk into your first and all future investor meetings.
Starting up: what you need to know about classic valuation methods
In order to ascertain a companys value in M&A (meaning mergers and acquisitions) practice, most businesses use a standard valuation method called Discounted Cash Flow (DCF). This method depends on data from the company’s 3-year financial plan, including:
- A profit-and-loss statement
- The company’s investments, including capital expenditure
- The company’s working capital requirements
By gathering this data, a company can define its free cash flow for the next three years.
Together with a high-level financial plan for years 4 through 6, a company can achieve rough overview of its free-cash flows for the next 6 years. This data is then used to calculate a company’s enterprisevalue from three key values:
- A company’s capital structure
- The company’s risk or debt
- And a discounting factor
Why standard valuation tools do not work for startups
You may be asking yourself: how can I possibly have these documents or know these values at this early stage of my startup? Don’t worry. Most founders can’t know these values, particularly when it comes to pre-revenue valuation. DCF and other classic valuation processes emphasize parameters that aren’t crucial for startups. Post-revenue valuation is simply different than pre-revenue valuation.
Startups are particularly different from other companies, in that:
- Their 3-to-6-year plan depends on far more variables and has more uncertainty.
- It is difficult to identify which discounting factor will cover the wide range of risks involved in startups.
- Business models change often and quickly during the startup phase, and these changes are not reflected in the classic DCF method.
- Startups are typically cash-negative in their first few years, so valuation primarily stems from the Terminal Value.
- When a startup is pre-revenue, valuation is negative, but this negative valuation does not actually represent the value of the company.
How to make valuation methods work for you and your startup
Since standard valuation methods require stability that startups cannot promise, a number of other valuation methods have been established. These include:
- Risk Factor Summation or the Scorecard Valuation Method: both of these valuation methods rely on a comparison and are good valuation methods for pre-revenue startups. To use these valuation methods, you choose another startup in the same industry, region, and stage of growth and compare it to your own startup. The differences between your company and this comparable startup are then factored in by using a standard investor-proven framework.
- The Venture Capital Method:this method is great for startups because it’s designed to deal with the uncertainty of development, focusing instead on the potential of the startup’s exit value.
- Transaction Multiples: this method is ideal for startups that have some revenue, but still are cash and/or EBITDA-negative. It is another valuation method that engages comparables, and therefore helps startups overcome the typical limitations of DCF.
- The First Chicago Method and many more!
How to choose the perfect startup valuation method for you
So which valuation method is ideal for your startup? The simple answer is: it depends. Just as the nature of any startup is volatile until the business has become more established, the valuation outcome is also highly changeable.
The first step towards startup valuation is narrowing down your possible methods. At the very basics, you will require a defendable minimum to maximum valuation, for which you can explain the benchmarks and assumptions that you made based on your specific financial model.
But don’t overthink things! You might want to consider startup valuation less as a specific amount, and more like a process that combines several methods to derive your solution space. In this way, the one perfect startup valuation method actually becomes a range of valuations achieved through using several different methods in parallel.
If youre still not sure which valuation methods are suitable for your stage of a startup, check out our valuation method checklist here.
6 steps for calculating your startup valuation
Don’t worry if you’re still unsure exactly how to proceed with your startup valuation. The wide range of startup resources at key2investors provides you numerous tools for understanding where to start and how to proceed. Here’s a brief overview in six clear steps:
- First, you’ll want to define comparable transactions, industries, stages, and regions for your startup.
- Then, find data on comparables and base valuations. We can help you with that here.
- Find out which valuation methods are the right ones to use for your stage of startup. Check out our resources for evaluating valuation methods here.
- Use 3 of these relevant valuation methods in parallel. Find out more about this process here.
- Then, set your assumptions and benchmark them in order to build an assumption register, as well as a benchmark register.
- Finally, define your valuation range as a defensible solution space.
Learn more about valuation methods
Find even more resources on valuation methods, capital raising, and startup valuation tools on our platform. By working through our fundraising masterclass videos you are just a couple steps away from confidently walking into your first investor meeting!