Startup Valuation Methods
Five Ways How to Value and Calculate Startup Valuations
We'll cover five different methods for valuing startups, concentrating on valuing early startups and those that are in pre–revenue stages.
1. The Berkus Method
This method, which is used and defined by active angel investor David Berkus, involves a lot of estimation. The reason Berkus came up with the method is that he personally found that lengthy revenue forecasts rarely turned out to be accurate. According to Berkus, only 1 in 20 startups hit revenue forecasts, so he opted for an "eyeball" approach using a few key elements. The method applies best to technology companies, but can be applied to other products.
First, Berkus says that investors should believe the company has a potential to hit $20 million or more in revenues by the 5th year of operation. Then, he applies a scale to five components of a startup, rating each at up to $500,000. The components are:
· The startup has a sound idea–a product that provides a basic value with acceptable product risk
· There is a prototype, which reduces technology risks
· The startup has or plans for a quality management team to reduce risks in execution
· Strategic relationships are already in place, reducing risks for competition and market
· Product rollout and sales plans exist (not applicable to all pre–revenue startups)
Using the method, the highest valuation would be $2.5 million; a pre–revenue startup could only score $2 million. This is a very back–of–the–envelope method, but it can be a useful tool for angel investors evaluating startups in the earliest of stages.
Some disadvantages do exist with the Berkus Method, however, illustrating the point that no type of data should be considered in a vacuum. For example, this method doesn't consider market or competitive environment, which may be of importance in many situations.
2. Comparable Transactions (“market comps”) Method
A comparable transaction is a common method used to value companies that are for sale, but it can also be used when considering startups. The basic principle is similar to the idea of valuing real estate based on what a comparable home on the street sold for recently, except investors have to take into account multiples of some kind because the new social media startup isn't going to have revenues and values equal to a company such as Facebook.
One comparable method calculation involves the EV/Sales ratio. The ratio is defined as the enterprise value of a company divided by its annual sales, or:
Market capitalization + Debt + Preferred shares – Cash and cash equivalents
You have to make sure you select one or more appropriate comparables – select companies from the same niche or industry that are as similar in market and solution to the startup as possible. When available, use startups from similar geography.
For example, you might have a startup with current annual revenues of $2 million. You could review a second company, which just sold for $50 million with annual revenues of $15 million, which is an EV/Sales ratio of about 3.3. Applying that ratio to your similar startup gives it a value of $2 million x 3.3, or $6.6. For a better chance at accuracy, you'd want to consider multiple comparables and value the startup at an average or median number.
The benefits of using a comparable approach is that you can pull information about existing companies from easily accessible data, and the calculations are simple and easy to communicate. Comparables also provide investors with benchmarks for valuations. Because actual data is used, however, the valuation could be influenced by temporary market factors that are not relevant to the startup being reviewed. It can also be difficult to find enough relevant comparable companies to get a good baseline for more accurate valuations. Investors can complete comparables valuations on their own, but some complex valuations may require the assistance of accounting professionals.
3. Risk Factor Summation Method
Like the Berkus Method, the Risk Factor Summation Method is a bit back–of–the–napkin. It does take more factors into account and applies to a broader selection of startups. The method considers 12 categories and applies a simple scale to each. The scale is:
· ++ (excellent performance)
· + (good performance)
· 0 (neutral performance)
· – (poor performance)
· –– (excessively poor performance)
The investor adds or subtracts monetary value based on the rating for each category as follows:
· ++ (add $500,000)
· + (add $250,000)
· 0 (no change)
· – (subtract $250,000)
· –– (subtract $500,000)
The 12 categories graded for startup valuations:
- Stage of the business
- Legislation/political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Let's look at how an investor might have used this method to value one of the hot software startups from a previous section: Apttus. Remember, this valuation has nothing to do with the company's current value, but might have been what an investor used before Apttus generated revenue.
- Management. In very early stages, investors might need to rate management based on the founder and plan. A case could be made for rating Apttus 0, +, or ++ at that stage, so let's use the middle rating and add $250k.
- Stage of the business. As we're discussing a very early startup, 0.
- Legislation/political risk. Apttus offers a service with little to know political risk, so ++ and $500k.
- Manufacturing risk. Apttus products are software, which means no manufacturing risk, so ++ and $500k.
- Sales and marketing risk. By linking up with Salesforce.com, Apttus minimizes its sales and marketing risks. Likely ratings might be + or ++; for this example, we'll use ++ and $500k.
- Funding/capital raising risk. Investors might look at Salesforce.com's history of funding and give Apttus a + rating solely on the likelihood of the larger software company chiming in with funds at some point, so $250k.
- Competition risk. The e–commerce sector is rife with competition, so an investor might get conservative here and rate Apttus ––, for minus $500k.
- Technology risk. Since Apttus planned to base its product on another platform, technology risks get at least –, or minus $250k.
- Litigation risk. This is tricky, as everything comes with litigation risks. Simply because the software deals with money matters, we might give it –, so subtract $250k.
- International risk. Probably minimal to none, so + for $250k.
- Reputation risk. While Apttus itself doesn't seem to have a large reputation risk, aligning itself with another company so closely does reduce its control, so a rating might be 0.
- Potential lucrative exit. We covered in the hot startup section that Apttus has a potential for sale to Salesforce.com, so ++ for $500k.
From these metrics, we come up with a valuation of $1.75 million for the fledging Apttus startup. Note that the example provided above used basic information to rate each element–the more information you have about a startup, the better you can rate and value it using this method. Like the Berkus Method, this is a tool for investors to use in evaluating a startup, and not likely to be a tool used to value a company during a purchase transaction.
4. Discounted Cash Flow (“DCF”) Method
Discounted Cash Flow valuations are the most complex of the five methods we're covering in this section and involve a series of formulas that take into account cash flow during a certain period and a discount rate applied based on the risks of the cash flow. The benefit of DCF is that it can be extremely accurate. The disadvantage of DCF is that a slight miscue on projections can throw the valuation off by millions.
DCF is particularly difficult to apply to early startups, which have little to no historic cash flow data to rely on. Established companies at least have past trends that can be built on to project future cash flow, but startups base that information on a lot of conjecture and guesswork. Some founders are better at others in that guesswork, and many can present data to back up projections, but it's safe to assume that a founder is going to err on the side of optimism when presenting his or her financials to investors.
Even with established companies and plenty of data, DCF valuations can go wrong. Pim Keulen of Seeking Alpha took a look at a DCF valuation of Nike in early 2015. Keulen cites an article by another Seeking Alpha author, Andrew Labutka. Labutka uses the DCF method to calculate a value for Nike of $107 per share, which was over the share price of $95.03 at the time. Keulen contended that Labutka made a few mistakes in his DCF analysis, including using incorrect number of shares outstanding and FCF numbers. By Keulen's calculations, Nike valuation would be between $60.06 and $63.22 per share–much lower than the company's stock price at the time.
The Nike example is a good one, because it illustrates that, even with a well–known, well–published company and DCF math, valuations can range widely. It also shows that even financial professionals using DCF can make small mistakes that skew final numbers by a great deal. DCF works much better with public companies vs. private companies.
5. Asset–Based Valuation method
Asset–based valuation is also known as book value valuation. Out of all the methods described in this section, asset–based valuation may provide the easiest way for investors to get a hard look at what a startup is currently worth in real value, but the number garnered through this approach isn't always helpful for angel investors evaluating a new opportunity.
In asset valuation, the original cost of all assets is adjusted by impairment costs and depreciation. The total physical asset values are added to any balance sheet values–cash on hand, accounts receivables, and other positive balance sheet items. Liabilities–outstanding debts or expenses–are subtracted from the total to get the asset–based valuation.
The problem with this method in valuing startups should be obvious: investors aren't betting on the current state of the startup, but on the future state. Asset–based valuation fails to take into account the intrinsic value of ideas or the future success of the product. Investors can apply asset–based valuations to projected assets, liabilities, and cash flow, but you run into the same possible issues as with DCF models.
Overvalued Startups: Is Snapchat Overvalued?
Angel investors evaluating opportunities should never rely on a single valuation method. Employing one or more of the five methods above–or other industry methods–gives you a broader idea of whether a startup is going to return value. And remember, even when numerous industry experts are involved, consensus on valuation isn't likely.
In December 2014, Snapchat was valued between $10 billion and $20 billion. Many experts chimed in on this valuation, saying that Snapchat was overvalued because it generated almost no revenue. Others compared the app to Twitter, stating that Twitter had about 2.7 times the users Snapchat did and was valued at $23 billion; using quick and dirty comparative math, the users said Snapchat was not too overvalued at the $10 billion mark.
Whatever the online community has to say, Snapchat was successfully raking in investors at the time. Someone, somewhere, was using a valuation and evaluation method that made the startup attractive.
Startup Valuations - How to Calculate and Ways to Value a Startup
Interview with leading expert on startups and valuations
Valuations and startups is one of the enigma wrapped in an enigma. It's a tough process, but we're going to break it down for you at Angel Kings so that when you're looking to invest in a startup, you know beyond the people, the product, the execution and timing of the startup, what are the financials in putting into your term sheet.
There are five primary methods to value a startup. The first is the Berkus Method and it is based on this guy, Mr. Berkus, who decided to say evaluations are estimations so he assumed that companies should be worth around ... Or be worth roughly $20 billion within five years. The Berkus Method is just one of the evaluation methods that investors can use.
The second is what's called the Comparable Method. You take the enterprise value and compare it to the something similar. It is just like buying a house on a street and finding out what the value is you look at a similar house on the same street to find what's called the comp. The comparable method is another way to value Startups.
The third way to value Startups is called the Risk Factor Method. You take several layers and several metrics and evaluate the risk and it breaks it down. The Risk Factor method breaks down into management, risk, and then exit strategy. We detail more of that on our site, but it's yet another way to value Startups, The Risk Factor method.
The fourth way to evaluate Startups is called the Discounted Cash Flow. DCF as it's better know, now the issue with valuing Startups with the DCF is you have to have a lot of historical data, a lot of historical numbers to determine what the startup would be worth. It's not used as much as opposed to publicly traded companies, but it is another way in which you can value Startups.
The fifth way to value Startups is called the Asset-Based Valuation Method, again if you have questions about that take a look at our site AngelKings.com. Taking all these five in place from the Burkes method to the Discounted Cash Flow, what's the best way to value a Startup? At Angel Kings we value startup in what we call the Best in Class scenario. It's a combination between a comps, what are other Startups in the same space being valued at their prime.
You'd look at a seed round of, for example, Slack App, an enterprise app, and you'd say, "Well, what's another company that ended up going public valued at that same time." Another thing about the Best in Class method at Angel Kings is you're able to see it a startup and what it's final exit strategy might be. If you're going to invest as we do at Angel Kings in another user based growth company such as LinkedIn, you would look to see how the users valued it on the public market.
In particular with LinkedIn now that it's publicly traded, you look to see how many monthly users are active, what are the metrics behind them? There's more about our Best in Class method on our website. Whatever you do as an investor, there's really no wrong way to go along as you're using the Angel Kings formula of people, product, execution and timing. We don recommend that you don't just pull it out of a hat and try to value a startup, you have to have some methodology.