Navigating the roller coaster of startups is hard enough, and valuations can be a thrilling yet daunting experience. That's why we're here to guide you through the winding maze of valuation methods. So, buckle up, and let's dive into the top 8 startup valuation methods to help you set a fair value for your ambitious plans.
Before we dive into the methods that Brex suggests in their article, we must take into account the following:
A Look at the Different Perspectives in Startup Valuations
How do you standardize something that varies through perspective, sector, stage, and many intangibles? You can’t. You can have a comprehensive toolbox that allows you to compare and contrast different methods and arrive at a more educated guess because who are we kidding here? There is no natural way of coming to a perfect number.
There are just so many variables that it is impossible. To make clear just how difficult this is, VCs that invest in pre-seed rounds might find valuations of 1M-20M post-money.
YC founder in demo-day will raise at a range of post-money caps of $20,571,429 according to Stonks study on the YC W23 batch. In contrast, we at Pygma see a valuation average of $3,000,000 Post-Money. This is a huge difference, considering some startups in YC don’t even have sales!
So, there, unfortunately, is no secret formula because finding the value of a startup is the same as trying to predict the future, but with a much more exact value in mind.
The Fabulous Frameworks: Mix and Match Your Way to Success!
Many VCs and angels follow different frameworks, asking questions like "Are the founders extraordinary?" or "Do I love the product/service?" Combine these frameworks to create your own unique approach. Remember, there's no one-size-fits-all solution in the world of startup valuations!
A Few Noteworthy Investor Perspectives:
- Founders Fund – This VC firm is all about secrets, anomalies, and accumulating advantages. They assess whether a startup has the potential to become one of the most important companies on the planet and if its founders can attract the talent necessary to achieve their vision.
- Naval Ravikant – Naval looks for technical teams, pure software companies, product usage, and revenue traction. He seeks founders with high energy, intelligence, and integrity, who are also the first credible movers in their space.
- Lightspeed – Their crucial question is, "Is the founder an A player?" because A players hire other A players, while B players hire C players.
- Jason Calacanis – Jason uses a value matrix to evaluate traction and valuation correlations, noting that prestigious founders often command higher valuations.
- David Zacks – David asks questions like "Can this explode?", "What is the product hook?", "What is the distribution trick?" and "What makes it hard to copy?"
These investors usually need at least 70% certainty to pull the trigger on an investment. The key for them is to find the right balance between due diligence and trusting their gut.
A Few Noteworthy Frameworks:
10X Mentality: Swing for the Fences!
Many investors are searching for 10x returns, seeking opportunities to increase their investment tenfold. Remember this mentality when pitching your startup, but remember that different funds and investors might have different expectations. Do your research, adjust, and advance.
Crossing the Chasm: Mass Adoption and the Leaky Bucket Dilemma
Early adopters have different needs than the masses, and crossing the chasm to reach mass adoption is challenging. Investors are wary of "leaky buckets" – startups with low retention rates, unsustainable customer acquisition pipelines, or costs. Aim for high retention and favorable growth rates to impress potential investors.
MVP isn’t everything
Some investors think the MVP is just a step in a series of progressive tasks to be completed to be aware of the other stages they might be looking for. These are some of the different steps a company might have to take before they reach it, and some investors like to enter at different stages. A Minimum Viable Idea, a Minimum Viable Concept, or a Minimum Viable Product are different stages that might even be in the same fundraising round.
Jobs to Be Done: Base Questions to Answer
Clarify your core audience, motivations, barriers, and competitors to ensure you know what job your startup is being "hired" for. Use frameworks like Minimum Viable Experiments and growth equations to refine your startup's value proposition. Always think, why is the customer hiring you?
The Riskiest Assumption Test: Validate Before Building
Test your startup's assumptions without wasting cash. Create a business model canvas and solid hypothesis, and run experiments to validate different items, like landing pages or waiting lists.
This allows you to save thousands of dollars and proves you can be a savvy investor of foreign resources once they come to you.
Due Diligence Sweet Spot: Striking the Right Balance
Investors need a balance between too much and too little diligence. They might perform reference checks or ask for deeper, intrinsic motivations. However, if you give too much, you might overcomplicate yourself, overextend your projections or seem like you were thinking too hard to sell the project instead of actually getting to PMF.
On this point, I always like to point out, it’s not wrong to have all the materials ready and be prepared, but maybe refine your strategy and how much info you are giving with an organized pipeline that tells you in what stage of the process each investor is and what blockers are they having towards finalizing their investment.
Milestones: Overcoming the "You're Too Early" Objection
When investors say, "You're too early," ask them which milestone would make them comfortable revisiting the conversation. This tactic sets a clear goal for future follow-ups, making them feel attached to your project even before investing.
Benchmarking: Know The Competition
Acknowledge your competition and industry benchmarks to show investors you're well-informed, and it can be done. How big were your competitors' rounds, at what valuation, and what milestones did you have? Are you really doing something completely different from them? If not, why will you become the winner in the market? Use factual data on competitors and referents to better compare and defend your company. Don’t be afraid to show your competitors. What you should be afraid of is a VC or investor knowing more about the market than yourself.
Now, let's get down to business. With all of these in mind, it’s never an insufficient exercise to test out some of the most recognized valuation methods so you can have different ways of defending your value.
The 8 different valuation methods:
- The Berkus Method: Simplicity at Its Finest
Imagine having a crystal ball to predict the value of your pre-revenue startup. The Berkus Method isn't that magical, but it's close enough! This easy-to-use method cuts through the clutter of complex financial projections by assigning dollar amounts to five key success metrics. Simplicity is essential, and the Berkus Method delivers just that. It is primarily used for pre-revenue startups named after the renowned angel investor Dave Berkus. The original Berkus Method defined five elements, each worth up to $500,000. Thus a pre-revenue company could be worth up to $2.5 million. The elements include:
- Sound Idea (Basic Value): This forms the startup's foundation. The idea should be unique, innovative, and have the potential for scalability.
- Prototype (Reducing Technology Risk): A working prototype reduces the risk associated with the product, demonstrating the idea's feasibility.
- Quality Management Team (Reducing Execution Risk): A competent team is crucial to the success of a startup. The team's experience, skills, and dedication can significantly reduce the execution risk.
- Strategic Relationships (Reducing Market Risk): Partnerships, collaborations, or any strategic relationship providing a significant market advantage is valuable.
- Product Rollout or Sales (Reducing Production Risk): Having a product in the market or even pre-sales can significantly reduce the risk related to production and increase investors' confidence.
Remember, these values are not strictly additive. If one of these elements is lacking or weak, it could devalue the others because they all contribute to reducing risk, which is the primary factor driving early-stage valuation. It's also important to note that while the Berkus Method provides a framework, it's ultimately up to the investor's judgment to determine how much each element is worth.
II. The Comparable Transactions Method: Because Comparison is the Name of the Game
We all love an excellent old comparison, don't we? This popular method has you looking at other startups in your industry to see how much they were acquired for. It's like sizing up your competition on the playground but with big-money stakes! So, watch for those industry multiples and adjust for any significant differences between your startup and the competition, or have a good reason to justify your value!
III. Scorecard Valuation Method: Score Big with This One!
Lights, camera, scorecard! This method offers a more comprehensive approach to valuing your pre-revenue startup. By comparing your business with funded competitors and scoring various qualities like team strength and market opportunity, you'll arrive at a valuation that captures your unique position.
The Scorecard Valuation Method, also known as the Bill Payne Method, is a popular method used by angel investors and venture capitalists to estimate the pre-money valuation of startups at the pre-revenue stage. This method considers a range of variables to assess the startup's value. Here are the main variables that it considers:
- Strength of the Management Team (0-30%): This typically includes the team's experience, knowledge, and skills relevant to the industry.
- Size of the Opportunity (0-25%): This is the potential market size the startup can address with its products or services.
- Product/Technology (0-15%): The product or technology's novelty, intellectual property, and potential competitive advantage.
- Competitive Environment (0-10%): The startup's competition in the market, including other companies offering similar products or services.
- Marketing/Sales Channels/Partnerships (0-10%): The strategy for reaching potential customers, including partnerships with other companies.
- Need for Additional Investment (0-5%): The extent to which the startup will need additional funding rounds to reach profitability.
- Other (0-5%): Any other factors that may affect the startup’s value, such as regulatory Environment, potential legal issues, etc.
Each of these variables is assigned a weight and a score. The average pre-money valuation of pre-revenue companies in the region is then adjusted based on these scores to estimate the startup's pre-money valuation. The weights mentioned in parentheses are typical, but they can be adjusted depending on the startup's specific characteristics or the investor's perspective.
IV. Cost-to-Duplicate: Copycats all around!
Ever wondered how much it'd cost to recreate your startup from scratch? Well, the cost-to-duplicate approach does just that! This method involves adding up your tangible assets and costs, like R&D and patent expenses. But remember, this method doesn't capture intangible assets, like your charming personality or your grandmother's secret recipe for success.
V. Risk Factor Summation Method: Assess, Adjust, and Value!
Ah, risk! The lifeblood of startups. This method starts with a base valuation, then adds or subtracts monetary values based on various risk factors. It's like playing a high-stakes game of "Would You Rather," except instead of deciding between skydiving and bungee jumping, you're evaluating management risks and competitive landscapes.
VI. Discounted Cash Flow Method: It's All About the Benjamins! (Not for pre-revenue).
The Discounted Cash Flow (DCF) Method is like the wise old uncle of valuation methods, looking at forecasted future cash flows and applying a discount rate. You might need the help of an analyst or investor for this, but it's worth it if you're looking for a more established approach to valuation.
VII. Venture Capital Method: Getting Cozy with the VCs
This method, beloved by venture capital firms, is perfect for pre-revenue startups and focuses on anticipated return on investment (ROI). By calculating your startup's terminal value and working through the formulas, you'll land on a valuation that reflects the mindset of investors looking for a profitable exit strategy.
The Venture Capital Method estimates a startup's value using these steps:
- Estimate the startup's future exit value: Estimating potential revenues or earnings at the exit time and applying a suitable multiple.
- Estimate the post-money valuation: Discount the future exit value to the present using a high discount rate to reflect startup risk.
- Determine the pre-money valuation: Subtract the investment amount required from the post-money valuation.
For example, if a startup is expected to be sold for $200 million in 5 years and requires a $5 million investment, with a discount rate of 40%, the pre-money valuation would be $24.6 million. This is calculated by discounting the future value ($200M / (1 + 40%)^5 = $29.6M), then subtracting the investment ($29.6M - $5M).
VIII. Book Value Method: Cracking Open the Books
Lastly, the Book Value method gives you a simple asset-based valuation. By subtracting liabilities from total assets, you'll arrive at the net worth of your startup. It's like balancing your checkbook but with your company.
Okay, that’s cool. What’s next?
Valuation is just one of the components of fundraising. Get savvy of the VC and startup Latam ecosystem by applying for our acceleration program, which is still open. You will access a lifetime community of startup CEOs and valuable actors from the ecosystem who will help you grow your startup to the next level.