Does Your Current Valuation Method Match Your Company’s Scale?

You must choose the right valuation method based on your company’s size to get an accurate financial assessment. If your company is an early-stage startup, it may lack a substantial financial history. Similarly, even for expansion-stage startups, it isn’t easy to find comparable companies.

Such issues are not present in growth-stage startups. Hence, at this point, more sophisticated valuation methods can be used.

Going a step further, it is safer to assume that a large corporation will exist perpetually than to assume it will exist only for the next 5 years.

Because these key characteristics change with scale, you must choose the right valuation method for your company’s scale. Through this article, you will learn how to do just that. Read on to know more!

Early-stage startups

At early-stage startups, there is not much data to go on. At this stage, your company may not have a product much less have a financial history to base financial projections on. Hence, using complex valuation models can give you a false sense of accuracy. To use the sophisticated models, you may need to make various assumptions where usually you would just rely on cold hard data.

This is why qualitative startup valuation methods like the Berkus and scorecard methods are used for early-stage startups. In slightly advanced startups, when your startup progresses beyond the idea stage and has a product, you can use the cost-to-duplicate valuation method. Let us go over these valuation methods.

Berkus method

In the Berkus method, you need to evaluate five risk factors and assign a value from $0 to $500,000 for each factor. These risk factors are:

• Business idea
• Prototype
• Management team
• Strategic relationships
• Early customer traction

In this method, a startup can have a maximum valuation of $2.5 million if it scores perfectly in all five risk factors. The objective of this method is to gauge the startup’s potential instead of its current standing.

This method is primarily used by angel investors and early stage venture capitalists who focus on startups that have not generated any revenue yet but show potential through assessments.

Scorecard method

In the scorecard method, we compare a startup with a similar and usually bigger company that has recently been valued. We take the valuation of the bigger company as a baseline and adjust it based on the additional risk one must take to invest in the startup. Typically, we adjust the valuation based on the following factors:

A Bain & Company survey indicated that 62% of responding organizations globally utilized the Balanced Scorecard, which is related to the Scorecard Method regarding strategic management tools. In a study in Ivey Business Journal focusing on Canadian firms, 23.5% of surveyed companies reported adopting the Balanced Scorecard approach, which may reflect similar trends for the Scorecard Method in early-stage valuation contexts.

This method is favored among angel investors and early stage venture capitalists for valuing pre-revenue startups.

Cost-to-duplicate method

The cost-to-duplicate method is a straightforward valuation method typically used for startups whose products have not hit the market yet. Here, the valuation is equal to the cost of replicating or replacing the existing assets and technology of the startup. The sum of all expenses necessary for building a similar startup from the ground up is taken as the valuation of the startup.

Expansion-stage startups

Expansion-stage startups have already established a product-market fit and now need to improve the product features and visibility to improve their standing in the market. These startups have yet to generate consistent revenue but have moved past the ideation and prototype-building phase.

So, you should use the valuation methods mentioned earlier in combination with quantitative valuation methods like the discounted cash flow (DCF) method and the Gordon Growth Model (GGM). You will need to assign weights to each valuation approach (quantitative or qualitative) based on how advanced the startup is.

Discounted cash flow (DCF) method

The DCF method involves using the startup’s financial history to forecast cash flows for a period for which the startup can reasonably be expected to exist. Then, these cash flows are discounted using the company’s weighted average cost of capital (WACC). Summing up all of these discounted cash flows will give you the startup’s valuation.

Venture capital (VC) method

This method is named the ‘venture capital method’ because of its utility for venture capital firms. In the VC method, we estimate the future exit value through liquidity events such as acquisitions and initial public offerings (IPOs). This estimated exit value is then discounted using the desired rate of return.

Growth-stage startups

Growth stage startups have moved past the early development phase which mainly involves building a prototype, finding a product-market fit, and starting to generate consistent revenue with an established customer base. At this point, there will be sufficient data to rely mainly on quantitative valuation methods such as the VC and DCF methods.

The ready availability of data and the advanced stage of the startup allow for accurate benchmarking against similar companies. Hence, growth-stage startups can also be valued using market-based approach valuation methods such as:

Comparable company analysis (CCA) method

In the CCA method, you need to find a publicly listed company similar to your startup. Then, you need to apply the valuation multiple of the listed company to your startup’s financial figures such as EBITDA or revenue to get an intermediate valuation.

To get the actual valuation, you must discount the intermediate valuation for factors like risk, growth potential, and the illiquidity of your startup’s equity.

Revenue multiple valuation method

In the revenue multiple valuation method, you will need to find out the revenue figures and valuations of various startups similar to your startup. For this data, you can look at recent funding rounds and acquisitions. Then, you need to divide the sum of valuations by the sum of revenue to establish the revenue multiple for the market. This revenue multiple can be applied to your startup’s revenue to find its valuation.

Established companies

At established companies, there is not only abundant data available but also a significantly lower risk of liquidation or dissolution. So, you can use the DCF, VC, CCA as well as the revenue multiple valuation methods. Additionally, the low risk of liquidation or dissolution enables you to use the Gordon Growth Model where a company is assumed to grow eternally at a constant rate.

Here, you must estimate the company’s next year’s dividend, the required rate of return for investors, and the expected constant and perpetual growth rate for dividends. Typically, the output of this model is the current stock price and not the company valuation. However, you can find the company valuation by multiplying the current stock price by the outstanding shares.

The formula for the Gordon Growth Model is as follows:

Current stock price = Next year’s dividend / Required rate of return-Expected contant and pertual growth rate

When should you use market and asset-based approaches to valuation?

The market-based approach should be used when a company has significant revenue and there are a substantial number of comparable businesses whose valuation and financial information are available.

This approach allows us to incorporate current market trends into the valuation. This valuation method is also much simpler than others and can be useful for investors who just want to estimate the current market value of their stake.

The asset-based approach is useful for valuing asset-heavy companies like real estate firms and distressed companies that may soon be liquidated. This method can be inaccurate for companies whose cash flows are primarily derived from intangible assets, such as intellectual property, brand value, or customer relationships. In such cases, you may undervalue the business, as this approach does not adequately account for future earnings potential and market positioning.

Eqvista – Your partner in comprehensive valuation solutions!

For early-stage startups, instead of using quantitative valuation methods that require a lot of data, it is better to rely on qualitative methods like the Berkus or the scorecard method. Once your startup reaches the expansion stage, you can start using quantitative methods like the discounted cash flow (DCF) method or the venture capital (VC) method.

At the growth stage, you are more likely to come across companies similar to your startup which makes the market-based approach easier to use.

At established companies, you can use valuation models that rely on the assumption that the company will always exist.

If you need assistance with company valuations, Eqvista’s NACVA-certified valuation analysts are here to guide you through every step. We have provided valuation support for more than 19,000 companies. Reach out to us today to schedule a personalized consultation.