“Valuing a company is more of an art than a science.” Alejandro González, fund manager at Redwood Ventures.
In this article, you’ll learn about the different ways to value a startup from the early stages through Series A, as well as concepts related to company valuations. The topics covered are:
- What is value?
- Price vs. value
- Startup valuation by stage
What is value?
“A company’s value comes from its ability to generate cash flows for its shareholders.” One of a company’s goals is to generate cash flows for its investors, as well as solve a problem or seize a market opportunity.
A company’s ability to generate cash flows becomes increasingly tangible as it grows. As a result, the more mature a startup is, the more likely it is to succeed and endure over time. However, as its name suggests, venture capital is one of the riskiest industries, so the expected return corresponds to the risk assumed. Therefore, the earlier an investor invests in a startup, the greater their return will be. But how much is a startup worth in its early stages, when it isn’t generating cash flows and may not even have a product yet?
Here’s how to value a startup based on its stage:
Idea
Valuing a company at the idea stage is very easy… The company is worth 0. Remember that ideas derive their value from how they are used and executed.
So as a founder, what can you sell an investor at this stage? Here are a few things to consider:
- The founding team’s experience
- The ability to turn the idea into reality
- Technical ability
- A positive track record with other ventures
- Progress to date
In addition to your experience and capabilities as a founding team, you’ll need a frame of reference to quantify the initial investment. Here are 3 methods you can use at this stage:
- 5x to 10x the amount raised. Multiply the amount needed by a number between 5 and 10 to get a “valuation” based on multiples.
- Initial valuations of similar companies. Find similar companies and research what they were worth at an early stage.
- Cost to replicate. If an investor wanted to execute your idea, how much money would they have to invest?
MVP, Prototype, or Pre-Revenue
At this stage, valuation methods are still qualitative. Commonly used methods include the Berkus Method, the Risk Factor Summation Method, and the Scorecard Method.
These methods are generally used by incubators or accelerators.
Initial revenue
At this stage, the company’s financial results begin to matter when calculating its valuation, meaning the process becomes quantitative. The most commonly used methods at this stage are the Venture Capital Method, First Chicago Method, and expected valuation in the next round.
Recurring revenue and growth
At this stage, the startup has validated the problem and solution and has a financial track record that can be used to make more accurate projections and calculations. The methods used at this stage are discounted cash flow, comparable multiples of public companies, and comparable M&A multiples.
Conclusion
There is no valuation method that applies to every company. The method and valuation can change depending on the company’s stage, industry, circumstances, and even the availability of capital and the attractiveness of the market.
Also, always remember to be the one to propose a valuation to the investor instead of waiting for them to give you one. Likewise, no valuation method is exact; ultimately, a company’s value depends on the laws of supply and demand.
To take a deeper look at the valuation methods mentioned here, we recommend checking out our latest content on valuations.