Valuation of a startup – methods and ways

Valuing a startup is quite a difficult task, as it is a fledgling venture and it is not entirely clear what its financial performance will be. However, it is sometimes necessary to do so, for example for the purposes of equity transactions. It is therefore worth knowing how to properly value a startup – for example, in order to successfully attract investors.

In this article you will learn:

• What is a startup valuation?
• What are the reasons for valuing a startup?
• What factors should be taken into account when valuing a startup?
• What is a DCF valuation?
• How to use public transactions when valuing a startup?
• What is replacement method?
• What is scorecard method?
• What are the benefits of proper startup valuation?

Startup valuation – definition

Valuing a startup involves verifying its financial value. It can be quite a challenge, not least because of the company’s short financial history. When carried out properly, however, it is crucial in terms of the company’s continued operation and growth strategy.

A startup valuation is the process by which the financial value of a company is assessed at an early stage of its development.

Definition of a startup valuation

When valuing a startup, it is extremely important to take into account the relevant factors affecting the value of the company and to select an appropriate method so that the entire process can be carried out correctly.

Reasons for valuing a startup

The startup valuation process makes it possible to determine the value of a startup in the context of investments and potential transactions – these can be mergers and acquisitions. There are several reasons why entrepreneurs value their startup. First and foremost, doing so allows investors to estimate the potential return on investment. Without a clear valuation, investors risk investing funds in projects whose return potential is not clear. Valuation therefore provides a tool to assess the profitability of an investment.

Of utmost importance is the fact that startups are often not based on physical assets, but on intangible assets such as know-how, unique technologies or intellectual properties. In addition, due to the short period of operation, the lack of stabilised revenues prevents the use of traditional business valuation methods based on a company’s financial history.

Start-ups usually start with an idea, having first and foremost the knowledge and business concept. Despite the lack of tangible assets, such ventures have value. The right valuation method must be tailored to the phase of development the startup is in. This means that the early stages of development require flexibility and the use of methods based on potential, growth prospects and unique elements of the project.

Relevant factors when valuing a startup

There are many factors that influence the valuation of a startup. These need to be taken into account throughout the process in order to get a realistic value for the business. Important factors when valuing a startup are:

Innovation of the product or service

When assessing the value of a startup, consider the innovation of the product or service offered. Uniqueness and possible competitive advantages can significantly affect the value of your business.

Stable customer base

Startups often operate in an environment where transactions may be incidental and a stable customer base is not yet established. This approach requires consideration of specific business risks. This is why, when valuing a startup, it is very important to take into account regular customers with whom contracts have been signed for a longer period of time. In the case of products, these could be shops that buy your goods in bulk.

Revenue deficit in relation to needs

In the first phases of a start-up’s development, fluctuations in revenue are frequent and income can be volatile. The value of the business needs to reflect this risk and the prospects for future revenue growth. You can also estimate the revenue your startup can count on in the future.

Development phase of the startup

The development phase is very important in valuation. Each stage of a startup’s development has its own characteristics, data and degree of business maturity. The appropriate valuation method should be tailored to the phase, which will provide more reliable information for investors. There are several phases of startup development:

• Pre-seed stage – this is the initial stage where the idea is in development and the startup is just getting started.
• Early growth stage (early stage) – this is where the startup already has the first data, in terms of customers, and activity increases.
• Growth stage – this is the phase where the company is growing rapidly and its revenues and users are steadily increasing.
• Expansion stage (expansion stage) – this is the stage where the company seeks to expand into new markets or segments.
• Maturity stage (exit stage) – when the startup is ready to sell or go public. The valuation here takes into account the results achieved, the potential for future growth and the attractiveness to external investors.

DCF valuation

The DCF valuation method is one of the most widely used techniques for assessing the value of a company, including startups. It involves estimating future cash flows – both revenues and costs – and then discounting them to present value to determine the value of the company.

For young startups that do not yet have significant historical financial data, DCF valuation becomes a challenge. Instead, the valuation can therefore be based on forecasts of future financial performance, which can include projected costs, revenues and cash flows. However, forecasting over a longer period, such as the usually accepted three-year period, can be difficult due to the dynamic nature of the market and the uncertainties inherent in the development of a startup. Why is DCF so challenging? This is because of:

• the lack of historical data – startups typically do not have many years of financial data, which makes it difficult to make accurate forecasts,
• the dynamic nature of the market – the industries in which startups operate are often subject to dynamic change,
• low predictability – in the early stages of development, revenue and cost forecasting can be much more uncertain due to the unknown reception of the product/service in the market,
• the volatile nature of a startup – startups often change their company business models and strategies in response to changing market conditions.

Public transactions and valuing a startup

If you are not sure how to value your startup, then you can use public transactions and market events. How exactly do these help you with valuation? Analysing the prices that other investors have paid for similar companies provides a benchmark for valuing a new startup. Information on such transactions is often available in trade media or market reports.

If a startup has attracted significant investment or has become very popular with users, this can be important in assessing its value. Investments by well-known investors or capital support can influence the perception of a company’s potential. Analysis of publicly listed companies on the market, will provide you with a number of benchmarks to help you approximate the valuation of a startup. However, due to the private nature of the startup being valued, it may be necessary to apply a discount to account for differences in the level of privacy and ability to access information.

Replacement method

The replacement method is one of the main methods for valuing startups, especially for internet or technology companies that rarely have physical assets or recognisable brands. This method is based on estimating the investment made by the originator to develop the project, taking into account a variety of elements, including:

• Time and work on the project – estimating the time spent developing the project and multiplying this by the hourly rate prevailing in the market.
• Creation of documents, prototypes, concepts – valuing the documents, prototypes, concepts or mock-ups created, according to the market rate for such services or production.
• Contracts and letters of intent – in the case of having signed contracts or letters of intent that can bring a specific revenue to the company, valuing these contracts and the projected value of the revenue resulting from them.

This method attempts to estimate the value of the startup based on the outlay that the originator has made in developing the project. It is particularly useful when the company does not yet have tangible assets or generate revenue.

Scorecard method

The scorecard method, also known as the Bill Payne valuation method, is an approach often chosen by business angels, especially for seed-stage startups where the company is not yet generating revenue. The valuation of startups is based on various factors that directly affect their value. The main criteria of the scorecard method include:

• Board, entrepreneur, management (25%) – assessing the skills and experience of the board and founders of the startup, their ability to successfully lead the company and execute the business strategy.
• Opportunity for venture success (25%) – determining the potential for success of the venture itself, analysis of business plans and strategy, assessment of potential growth and ability to succeed in the market.
• Technology/Product (15%) – assessing the innovation of the product or technology, uniqueness and possible competitive advantages in the solution offered.
• Marketing/Sales (15%) – analysis of marketing strategy, sales skills and planned market penetration, ability to attract customers and build user base.
• Need for additional funding (10%) – an assessment of whether the company will require further funding, and planning for additional capital for further growth.
• Other (10%) – other factors that may be relevant for assessing the value of a startup, such as synergies with existing investors, specific industry trends or investment risks.

The scorecard method is flexible, allowing the evaluation of different aspects of a startup’s performance, paying attention to specific characteristics and success factors. Nevertheless, it is important to bear in mind that the evaluation of each criterion and their weights may vary depending on the specific situation, so this method requires subjective evaluation and is more conventional than other valuation methods.

Benefits of a proper startup valuation

A properly conducted valuation of a startup is a key element for its development and future success. This is because the process allows, among other things:

• verification of progress to date,
• strategic planning,
• building credibility on the market,
• attracting investors,
• effective negotiations with investors,
• effective preparation for future funding rounds.