Startup Valuation: Art or Science?

Valuation is the simple job of estimating how much people will be willing to pay for a given good. In consumer markets, this is simple. You take your product, and ask people how much they’d be willing to pay. This is called market research. But for financial institutions, this is a bit more complicated.

Stock brokers have the easiest job, by far. They have a market they can refer back to, and, unless the market is highly volatile, the price stays relatively predictable. Same, too, for options traders. There are extensive formulas to calculate the price of an option based on the strike price, duration, and the risk free premium of the market.

It gets progressively worse, until you hit venture capital. But, before we move on, we should first talk about the 9 ways venture capitalists value your company.

The 9 Ways of Valuation

Berkus Method

When we talk about startup valuation, most people think of valuing based on gut feeling. The Berkus method is, what seems to be, an effort to put a science to this art. Pioneered by angel investor Dave Berkus, it give 5 categories for people to judge a startup, with each category being worth $500,000. The categories are as follows:

If Exists: Add to Company Value up to:
Sound Idea (basic value) $1/2 million
Prototype (reducing  technology risk) $1/2 million
Quality Management Team (reducing execution risk) $1/2 million
Strategic relationships (reducing market risk) $1/2 million
Product Rollout or Sales (reducing production risk) $1/2 million

Source: https://berkonomics.com/?p=131

Note that a valuation based on this method tops out at $2.5 million, which will be discussed later on. This is, based on what I’ve seen, the primary valuation method used on shows like Shark Tank. It goes without saying that, though this method can be applied to most companies, there are exceptions where this may not be suitable, even in the angel stage.

Risk Factor Summation

This is similar to the Berkus method, but it divides up the criteria into 12 factors, instead of 5. Moreover, each criterion is scored on a scale from -2 to 2, with every point being valued at $250,000. The criteria is as follows:

  • Management
  • 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

So, if your management is very competent (2) but your competition risk is also very high (-2), and everything else is a normal risk to the company (0), then the cumulative score would be a 0. Your final valuation is:

Cumulative Score x $250,000 = Valuation.

The maximum valuation (hypothetically) would be $6,000,000 using this method.

Bill Payne Method

This method involves finding the median value of startups at that stage, and then comparing them based on 5 categories, each with a different weight. This is very different to what the previous methods have done, which is to value each category the same weight. Below is a sample calculation:

Source: https://startupsventurecapital.com/valuation-for-startups-9-methods-explained-53771c86590e

You multiply the team’s capacity (in %) compared to the average competitor, then multiply it by the weight of each category. The cumulative sum of these products is called the multiplier. This is multiplied to the median value of comparable startups, giving us the final valuation.

Comparable Transactions Method

This is a straight forward method, where you compare the startup with its competitors to get a valuation. Usually, the numbers used are traction related, like revenue, or profit, or even MAU. The ratio of the startup’s numbers compared to its competition gives use the ratio the valuation should reflect.

Book Value Method

The book value method is purely valuing a startup based on its assets. Pretty straight forward.

Liquidation Value Method

This method involves valuing the startup based on the liquidation value of its assets.

So what makes this different from book value method?

If you’ve ever taken accounting 101, you’ll know the book value depreciation figures don’t reflect real world market prices for used and depreciated goods. The latter prices are known as liquidation values.

DCF (Discounted Cash Flow)

This is the first method of valuing a project you learn in business school. If you’re unfamiliar with the formula, here’s a refresher from Investopedia:

Discounted Cash Flow (DCF)

The discount rate is the rate of return on a project of similar risk.

The main value proposition of this is that the valuation given favors the business owner, especially considering that, if one takes the money and invests it in a similar risk project, the end result should be the same as the cash flows of the business.

The downside is that this requires the cash flow forecasts to be highly accurate — something that’s almost guaranteed not to happen with a startup.

First Chicago Method

This is the method most new business classes, and even entrepreneurial classes, will teach you. It involves the famed “Best, Normal, Worst” case scenarios to value your business.

Source: https://startupsventurecapital.com/valuation-for-startups-9-methods-explained-53771c86590e

Problem is, the valuation in each of these scenarios are based on either IRR, or, more commonly, DCF models. You can see where the problems may arise.

Venture Capital Method

This method is, by far, the most interesting. It involves working backwards, using your goals as the assumed variables. This is a common method in PE funds, particularly in LBO situations. But, instead of leveraging returns using debt instruments, the returns are inflated to “better reflect” startup environments.

Source: https://startupsventurecapital.com/valuation-for-startups-9-methods-explained-53771c86590e

What you see above is essentially the answer to 2 questions. First, how much do I think the startup is going to be worth at exit, and second, what’s the return I want from this investment?

Problems

The problems with most these methods are that they require a lot of intuition. Apart from the book value method, and the liquidation value method (2 methods that are used in cases of bleak futures), all other valuation methods require the use of either forecasts, or comparables.

Berkus method, and the risk factor summation method in particular, both require the investor to judge a startup based on intangible facets of the business. The first Chicago, and the DCF methods require one to believe in the forecasting abilities of the entrepreneur. The scorecard, and the comparable transactions methods requires one to quantify a qualification. The VC method is, essentially, using your goals to value what’s not yours.

There’s no perfect method. Especially for a startup without any revenues, or traction.

But that doesn’t mean that these are all, inherently, useless.

How to Value Properly

One of the biggest mistakes I committed during my early days in this industry was using the DCF, and first Chicago methods to value startups at their angel/accelerator round of funding. This isn’t inherently wrong, but the margin of error, in this case, would be astronomical. I quickly learnt from my mistakes, and did some homework. the following is at what stage each method should be used to maximum effect (probably).

Pre Seed

By pre seed, I mean friends and family, angel, and even accelerator rounds of financing. The Berkus method, and the risk factor summation methods are both adequate for this stage.

I personally prefer the Berkus method, because it’s easier to quantify based on how well the team satisfies what you’re looking for, rather than comparing them to an arbitrary 0 line. Unless, you’re familiar with the industry the company is looking to enter.

Or, if you’re an accelerator looking to fund startups with valuations of up to $6M.

Seed

This would be the first funding round after any angels or accelerators. By this stage, you should have some traction, especially with product, and early sales and partnerships. Or, perhaps, you have traction in MAU. In any case, the company should be comparable to some noteworthy companies, whose valuations are public. Scorecard and comparable transaction methods should apply here.

There is a limit to what the comparable transaction method can do. A lot of times, it can overvalue a company, especially in times of hype surrounding an industry. The scorecard method is more objective in this way, as you’re comparing the capacity of the factors in play, as opposed to the results reported.

Early Stage

Early stage means Series A and B. These are your most prominent series, where the bulk of the company’s traction begins to take shape. By now, there should be adequate market research to formulate solid forecasts. DCF and first Chicago would be the method of choice. It goes without saying that any funding stage post series B would be done in a likewise manner.

What About the VC Method?

The VC method is rather interesting, and troublesome. It’s interesting as it can be applied to all the aforementioned situations. It’s simply working backwards from the answers you want. Just input the IRR, duration, and the final exit valuation, and you get the post money valuation you want for any given round.

Problem is, it’s mostly based on what the venture capitalist sees, not the founder. This is great for an investor, as it can bring down a valuation as it pleases, based on the assumptions it’s developed over the years. It’s terrible for founders, because VCs don’t often see the potential of a brand new market. They simply don’t have the data.

As a result, a lot of VCs will value your startup, particularly post seed, based on this method. It gives VCs leverage in negotiating a fair deal, acting as a counterweight, of sorts, to all the traction the startup brings to the table. For a venture capitalist, this is the go to method for any investment they make. Which is why I put it here, in its own section. If you’re a founder, however, this is one to avoid.

Valuation: Art or Science?

Valuing companies that are well established is a methodical science. Startups, not so much. Despite decades of efforts in Silicon Valley, there are still stories of inflated valuations, based on not much more than names and brands (e.g. Theranos). In fact, there are many calling this current market of startups a bubble.

But we’ve already had a bubble for startups. Back in the 90’s and early 2000’s.

The fact that we’re talking about another bubble in this industry is a testament to just how uncertain, and volatile, investing in startups is. There’s no scientific method to go off of, mainly because, there’s no historical parallel to draw upon.

In cases of an LBO, or even growth capital, it’s easy to find parallels to any given project. In fact, a simple Google search can probably find at least 10, easy. But, when you’re trying to disrupt an industry, there are no guarantees. Not even one. In fact, it seems the best measure of future success is the gut feeling of an investor.

Valuation, in and of itself, is more art than science. But, it’s more like design, where the art is based in science. Startup valuation is more like fashion design — it shares the same roots as the overarching term, but it bases a lot less in science. The aforementioned methods are nothing more than tools to quantify a gut feeling, to give people a starting point from which to negotiate.

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