Business valuations regularly make the headlines. We can all recall examples of businesses achieving a gargantuan valuation - in many cases without even turning a profit.
The process of valuing a startup isn’t simple for a number of reasons. First of all, how do you value an idea? Does an idea even have a value if it’s not set into motion? And how important are people in this equation?
There are loads of methods for valuing businesses - some purely quantitative, others more focussed on qualitative factors - and it can be challenging to understand which method you should follow in determining the value of your startup.
In this article we’ll take a look at some of the reasons why you would want a startup valuation, before exploring the different methods for valuing a startup, both pre-money and post-money.
When do you need a startup valuation?
There are a number of different reasons that you might want a startup valuation, each of them will have different objectives and desired outcomes.
Contrary to popular belief, you aren’t always looking for the highest valuation possible - there are times when you might even want a low valuation for your business.
Here are the most common reasons that you might want to value your early stage business:
Before you can accept investment in your company, and give away equity in return, you need to have some notion of what your business is worth.
This ensures fairness for everybody involved, as on the one hand it ensures that you don’t give away too much equity, and on the other it gives investors reassurance that your business is deserving of their capital.
For an exit
When the time comes to exit your business, a valuation will be necessary in order to market and sell your company. Appraising the value of your business at this stage will be a case of seeking the highest number possible - after all, you want a good return for your blood, sweat, and tears.
For share schemes
A third reason that a founder would want to value their startup is for their company share scheme. Savvy founders know the value of rewarding their teams with equity, and obtaining a valuation is a vital step on this journey.
You will likely need multiple valuations during the lifetime of your company share scheme, especially if you are using an EMI scheme.
Now that we understand the reasons that you would want to value your early stage business, let’s take a look at the different methodologies for determining value.
Startup valuation models: Pre-money or post-money?
A key distinction to make in the arena of valuations is pre-money and post-money.
The term ‘pre-money valuation’ refers to the value of a business prior to investment or financing. It is calculated on a fully-diluted basis, and is accepted as the value of a business before anything is invested into it.
Investors, such as venture capitalists and angel investors, will use a pre-money valuation to determine how much equity they should ask for in return for their injection of cash. A pre-money valuation isn’t a static figure, and therefore it is likely to change each time the company is valued.
There is no single formula for a pre-money valuation, and we will explore some of the leading methods in the next section. If the post-money valuation is known, then the basic formula for a pre-money valuation is as follows:
Pre-money valuation = post-money valuation - investment amount
Unlike a pre-money valuation, a post-money valuation is the estimated value of a business after external investment or financing has been injected into a company.
Therefore, a post-money valuation is a simple calculation:
Post-money valuation = pre-money valuation + external investment
Pre-money methods for startup valuations
Here are a couple of the most widely used methods of determining a pre-money valuation of an early stage business:
Venture Capital Method
The Venture Capital Method was developed in 1987 by William A. Sahlman at Harvard Business School, and is a way of determining the pre-money valuation of a business.
It uses the following formulae:
Return on Investment (ROI) = Harvest Value ÷ Post-money Valuation
Post-money Valuation = Harvest Value ÷ Anticipated ROI
The Harvest Value is a business’ targeted selling price in the future. This is estimated using reasonable projected revenue and earnings figures for the year that the business will be sold.
Scorecard Valuation Method
A common quandary arises when a business is largely built upon ideas and ‘sweat equity’. These things can be difficult to determine the value of, and attempts often feel arbitrary.
The Scorecard Method, also known as the ‘Bill Payne Method’ after it’s creator, is a great way of finding a comfortable ballpark valuation for a pre-revenue start-up which uses industry averages and weighted percentages.
The Scorecard Method has four stages:
1. Finding an industrial average
The foundation of this method is the industrial average for pre-money valuations. In Bill Payne’s example, he surveyed the top 13 Angel Associations in the United States to find the average pre-money valuations of their portfolios.
Busy founders will likely not want the hassle of contacting investment associations, and so Crunchbase is a great resource for doing this. You should make a balanced selection, avoiding significant ‘unicorn’ outliers that could skew your averages.
2. Determining weighted averages
The second step in this method is to identify the strengths and weaknesses of different factors surrounding your business.
The scoring criteria and their weightings are as follows:
- Strength of the management team (0 - 30%) - Complete? Experienced? Coachable?
- Size of the opportunity (0 - 25%) - What is the potential size of the prize?
- Product/Technology (0 - 15%) - Is the IP well defined? Do you have traction?
- Competitive environment (0 - 10%) - Are there any barriers to entry?
- Marketing/sales channels (0 - 10%) - Do you have any key partners?
- Need for additional investment (0 - 5%) - Angel investors? VCs?
- Other (0 - 5%) - Are there any geo-political factors that affect your business?
3. Assigning comparison factors
In the third stage of this method, you need to assign comparison factors to your percentage weights from step 2. To do this, you must first identify what percentage of the total weighting that each factor receives (the comparison). In some cases, this could exceed 100%. To find your comparison factor, multiply the weighting of each category by the comparison that you have assigned it.
Assigning comparisons for some factors is easier than others. For example, it will likely be easier to determine the strength of the management team, but evaluating the sector and business environment might be more challenging, and will require some thorough research.
Once you have comparison factors for all of the scoring criteria, you must then add them all together.
4. Multiplying the sum of the factors
The final stage of the Scorecard Method is to multiply the sum of comparison factors from Step 3 by the industrial average pre-money valuation that you calculated in Step 1. This will give you your own pre-money valuation.
There you have it - your very own guide to startup valuations. We hope you found it helpful. We understand that this can be a complicated process. Our in-house valuations team do this every day, so if you need help getting a valuation for your company’s share scheme, then please get in touch.