Essentially, there are more than 5 valuation methods for startups. However, the top 5 methods on your list include the venture capital method, scorecard valuation method, comparable company method, risk factor summation method, and cost to duplicate method. These are the commonly used valuation methods.
Direct comparison approach
This is the most commonly known valuation approach. We analyze recent sales of comparable properties to determine the value of your property. In considering any sales evidence, we ensure that the property sold has a similar or identical use as the property to be valued.
While valuation can attract investments and strategic opportunities, profitability ensures financial stability and long-term sustainability.
Discounted Cash Flow (DCF)
Discounted cash flow analysis then represents an important valuation approach. DCF involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth.
Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow-generating assets. In theory (and in college final examinations), this technique works great. In practice, however, DCF can be difficult to apply in evaluating equities.
To determine a startup's valuation, you can use methods like comparable company analysis, the cost-to-duplicate approach and the discounted cash flow method. Each method offers a different perspective on what the startup is worth, depending on available data and market conditions.
Profitability and Cash Flow
A startup's ability to generate profit or maintain healthy cash flow, even at an early stage, is a key factor in determining its valuation. Investors look for startups that demonstrate financial stability and the potential for long-term profitability.
While rapid growth can create market opportunities and establish a brand presence, profitability ensures long-term sustainability and shareholder value.
The three most common investment valuation techniques are DCF analysis, comparable company analysis, and precedent transactions.
The Revenue Multiple (times revenue) Method
A venture that earns $1 million per year in revenue, for example, could have a multiple of 2 or 3 applied to it, resulting in a $2 or $3 million valuation. Another business might earn just $500,000 per year and earn a multiple of 0.5, yielding a valuation of $250,000.
- Use DCF for companies with significant future projects or growth forecasts. - Use DDM for companies with a stable and predictable dividend policy. - Use Price-Income for quick comparisons or when dealing with industry-standardized metrics.
There are three primary approaches under which most valuation methods sit, which include the income approach, market approach, and asset-based approach. The income approach estimates value based on future earnings, using techniques like the discounted cash flow analysis.
However, the seller's discretionary earnings (SDE) method is solely used for small business valuation. If you're planning on selling or buying a small business, the SDE method might be best because it can help the buyer understand how much income they can expect to earn each year from the business.
Three effective methods for valuing startups with no revenue are Comparable Transactions, Venture Capital, and Berkus. Comparable Transactions values a startup by comparing it to similar companies, but this is not always feasible if your startup is in a new category or has a highly innovative product.
Startups often see rapid early-stage growth, with average ARR growth of 144%, but as companies mature, this typically slows to 15%–45% year-on-year. Early-stage companies can track a 12–18 month trend or target a 10% weekly growth for faster expansion.
From an investor's standpoint, a company with opportunities to grow profits by increasing revenues is more attractive than one that relies on cost-cutting. However, both factors are important. Investors value companies that run a tight ship and have the potential to grow.
The Bottom Line. Profitability and growth go hand-in-hand when it comes to success in business. Profit is key to basic financial survival as a corporate entity, while growth is key to profit and long-term success. Investors should weigh each factor as it relates to a particular company.
Up to this point, generally speaking, with teams of less than 12 people, the average granted equity for startup employees is 1%. This number can be as high as 2% for the first hires, and in some circumstances, the first hire(s) can be considered founders and their equity share could be even greater.
Venture Capital Method
Venture capitalists commonly use this valuation approach to assess startups' worth. This method focuses on potential return on investment (ROI), future cash flows, exit strategies, and risk assessment to determine a startup's valuation.
While a 10% annual ROI might be satisfactory for a stable, blue-chip stock, startup investors often aim for average annual returns of 20%, with the potential for much higher returns if the startup succeeds.
The market approach involves using available data from comparable transactions or comparable companies as a basis of comparison for the startup. In this approach, you will blend your company's financial performance (and/or projections) with market data, such as trading multiples, to infer the value of your company.
For an early-stage to mid-stage startup with a straightforward business model and capital structure, you can expect to pay between $5,000 to $10,000 for a 409A valuation. More complex companies, especially those with preferred stock or many stockholders, will likely pay $10,000 to $25,000 or more.
The Berkus Method is a valuation technique for early-stage startups that emphasizes potential over financial metrics. It uses five key factors: the quality of the startup's idea, the presence of a prototype, the management team's capabilities, strategic partnerships, and readiness for product rollout.