How much is your startup worth? The million-dollar question—and one you’ve probably asked yourself +1 times. The short answer is: it depends on whom you ask. However, here we’ll provide you with tools and knowledge to value your startup reasonably and defend your valuation to investors, accelerators, or other interested parties.
With insights from Eduardo Peláez, an LP in LATAM investment funds and an angel investor in LATAM startups, you’ll learn about the qualitative and quantitative valuation methods a startup can use to determine its value.
Specifically, we’ll cover the following methodologies:
- Discounted Cash Flow (DCF)
- Venture Capital Method
- Scorecard Valuation
- Comparable Multiples
Startup valuation methodologies
In general, there are 2 types of valuation methodologies. The 1st type focuses on evaluating ongoing businesses—that is, it treats them as living entities that develop and generate value over time. The 2nd type evaluates businesses with a greater focus on the value of their assets.
In this article, we’ll focus on the 1rd type, since startups are always evolving and changing. The second type is more applicable to traditional companies.
So, for startups, we’ll take a closer look at 4 valuation methods:
- Discounted Cash Flow (DCF)
- Venture Capital Method / IRR Method
- Scorecard Method
- Market Multiples
Which methods should you use at each stage?
Depending on your startup’s stage, we recommend using the following methodologies at the corresponding stages.
Learn more about each valuation model below. We recommend watching the video for a direct explanation of the topics from the speaker.
Discounted Cash Flow (DCF)
The discounted cash flow methodology estimates a company’s value by projecting the cash flows it could generate in the future and then discounting them to present value using an appropriate discount rate.
Advantage:
The only methodology that aims to reflect the company’s actual current situation and incorporates all the variables that determine value creation (investments, expenses, and growth).
Disadvantage:
The number of assumptions required and the sensitivity of the result to changes in those assumptions.
Venture Capital Method / IRR Method
The VC Method starts with a future terminal value (potential exit) for the VC and uses it to work backward and calculate what the startup’s post-money valuation should be today.
In other words, at what valuation should the VC fund invest to achieve an exit with a certain expected return, taking into account dilution in subsequent rounds? Here’s an example:
Scorecard Method
This methodology compares the target company with typical companies funded by angel investors, then adjusts their average valuation using a weighted factor to arrive at a “pre-money” valuation.
This qualitative methodology is typically used at very early stages by incubators, accelerators, or angel investors. Criteria may include the founding team, competition, product, traction, and more. You can customize the factors as you see fit.
Market multiples
This method compares a company with other existing companies and identifies the multiple applied in a transaction (IPO, investment round, or acquisition) to arrive at a particular valuation. Ideally, the comparable company operates in the same sector and/or has the same business model.
One challenge with this valuation method is finding public information that can be used to make the comparison.
The multiple or multiples used for those companies will give you a reference point for which multiple you can use based on your stage and region. Valuing a company in LATAM is not the same as valuing one in the United States or Europe.
Which multiples are used?
The best-known multiples are sales, EBITDA, net income, number of users, or GMV.
Conclusions
As Brad Feld says in his book Venture Deals, “The only thing that we know about financial predictions of startups is that 100% of them are wrong”. For this reason, we recommend studying these methodologies here and in other sources, consulting experts, and choosing a valuation you feel comfortable enough to defend.
Also, remember that a VC fund doesn’t use just 1 type of valuation model, but several. In most cases, the final valuation it assigns to your startup will be the average of all the valuations made by the investor.