Business Valuation Methods
Valuation is the process of determining the present value of an asset. Valuations are needed for many reasons such as investment analysis and acquisition transactions.
1. Value Early Stage Startups With the Scorecard Valuation Method
Scorecard valuation method compares a target startup with other funded startups or ventures in the same region and calculates a pre-money valuation of the target startup. The scorecard valuation process involves three steps which are explained below:
Step 1: Find the average pre-money valuation of pre-revenue startups
This step determines the average pre-money valuation of pre-revenue startups in the region. This may vary according to the targeted startup’s business economy and competitive environment in the region. We recommend using Angellist or Crunchbase database to find the startup valuation data of startups within a region and then you can find the average industry pre-money valuation.
For example: Here we take an average pre-money valuation of industry pre-revenue startup in a specific region as $2.1 million.
Step 2: Evaluate the target startup keeping in mind other startup deals in the region and considering the following seven important factors.
- Strength of the Management Team (0-30%)
- Size of the Opportunity (0-25%)
- Product/Technology (0-15%)
- Competitive Environment (0-10%)
- Marketing/Sales Channels/Partnerships (0-10%)
- Need for additional investment (0-5%)
- Other (0-5%)
Step 3: Calculate the percentage weights
In order to find the percentage weight, we use the following table. Usually, the valuation score rating is assigned in the range of 50% – 150% with 100% for normal requirements to arrive at the weighted average rating of a startup.
In this example, we assume the target startup is having a strong management team (120% comparison) with a good market opportunity (105% comparison). Also, with a strong product and technology base (125%) and in an average competitive market (95% comparison). With the need to improve the sales, marketing, and partnership (90% comparison) and maybe the need for an additional investment (95%). Finally, the startup is getting an average feedback and responses about the product (100% comparison).
|Value Driver||Weight||Venture Score Comparison||Factor (WxV)*|
|Total Sum Factor||1.10|
|Strength of the Management Team||30%||120%||0.36|
|Size of Opportunity||25%||105%||0.26|
|Need for Additional Investment||5%||95%||0.05|
*rounded to two decimal places
Step 4: Multiply the sum of factors with the average pre-money valuation of the target startup
Example: Here we multiply the sum of factors (1.10) by the average pre-money valuation of the target startup ($2.1 million) the results of the survey. Now, we arrive at pre-money valuation of the target startup as ($2.3 million).
Valuation of Venture – 2,310,000
2. Value Early Stage Startups with Berkus Method
Berkus Method Valuation Calculator estimates your startup valuation based on the assessment of five key success factors which are also known as value drivers.
These five value drivers are:
- Soundness of the business ideas
- Quality or existence of a product prototype
- Quality of the business management team
- Strategic relationship in the market
- Existent product sales
The above five value drivers determine the pre-money valuation of your startup. You can assign the value between zero ($0) to five hundred thousand ($500,000) in each value drivers category allowing a pre-money valuation of up to $2 million -$2.5 million.
Below is an example of a startup pre-money valuation using Berkus method
|Value Driver||Add to Pre-Money Valuation||Assigned Value|
|1. Sound Idea (basic value, product risk)||$0-$500,000||$250,000|
|2. Prototype (reduces technology risk)||$0-$500,000||$275,000|
|3. Quality Management Team (reduces execution risk)||$0-$500,000||$300,000|
|4. Strategic Relationships (reduces market risk and competitive risk)||$0-$500,000||$300,000|
|5. Product Rollout or Sales (reduces financial or production risk)||$0-$500,000||$55,000|
3. Value Early Stage Startups with Risk Factor Summation Method
The Risk Factor Summation Method or RFS is another pre-money valuation method which also brings some specific risk management and governance consideration into the pre-money valuation of a target startup.
Step 1: Similar to Scorecard Valuation Method
Here also we need to find an average industry pre-money valuation of the target startup.
Example: Let’s take the pre-money valuation of pre-revenue companies in the region as $2 million.
Step 2: Next, we need to consider 12 risk factors associated with the startup and its industry.
These risk factors are:
- Management risk
- Stage of the business
- Legislation/Political risk
- Manufacturing risk (or supply chain risk)
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Exit value risk
Step 3: Assign ratings to each risk factor and do an adjustment to the average pre-money valuation of the startup
Ratings to each risk factor is assessed, as follows.
- +2 very positive for growing the company and executing a wonderful exit
- +1 positive
- 0 neutral
- -1 negative for growing the company and executing a wonderful exit
- -2 very negative
Then, the average pre-money valuation of pre-revenue companies in the region is adjusted positively or negatively based on each risk factor ratings.
- Risk Factor Ratings / Adjustments to pre-money valuation
+2 / Add $500,000
+1 / Add $250,000
0 / Add/Minus Nothing
-1 / Minus $250,000
-2 / Minus $500,000
Example: Let’s take an average pre-money valuation of a pre-revenue startup in a region as $2.5 million.
Then we judge the ratings of the 12 risk factors of the target startup as below
|Management Risk||+2||Add $500,000|
|Stage of the business||-1||Minus $250,000|
|Legislation/Political Risk||+1||Add $250,000|
|Sales and Marketing Risk||+1||Add $250,000|
|Funding/Capital raising risk||0|
|Competition risk||-2||Minus $500,000|
|Technology risk||-1||Minus $250,000|
|Potential Lucrative Exit||+1||Add $250,000|
Step 4: Add the Average industry pre-money valuation with the sum of adjustments
In this example, our average industry pre money valuation is taken as $2.5 million and above we got adjustment sum as $250,000. Now we add both these and we get ($2,500,000 + $250,000) the pre-money valuation of the target startup as $2.75 million.
4. Working Capital and 20% Margin – Valuation Method
Early stage seed investors would always like to invest in a good idea and good team or people. Since the ideas are of little depth, they give more importance to execution. It is also a fact that most Venture Capital firms will prefer to invest in a team who execute and know how to get their product done and introduce same into a market. Seed investment refers to a series of related investments in which 10 or fewer investors “seed” a new venture with anywhere from $50,000 to $2 million. This invested money is mostly used to support the first stage of market analysis and product development.
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However, if you only have an idea and team then it is better not to look for a rising pre-seed investment (usually $200,000 – $500,000). Rather, get some initial money using your product idea or concept from your close circles. Once you have a product, team and potential clients it is advisable to look for seed investment even if your company has zero revenue.
Thus, in effect, we at Eqvsita came up with a simple and logical method which might fit your need if you will be looking for any seed investment.
It is very important for your startup to plan a budget for the next 18 months. Your runway is as long as 18 months and you need to make sure that you will receive investment covering this period.
For example, our new product in Eqvista has been done within 7 months so we have 11 months to get clients and some market share. Therefore, it is possible to get your product done within 6-7 months.
Another important part of the valuation process is how big your team should be. If you know that you will need 6-7 months to launch your product, you need to calculate how much you will require and how many people you may need in your team.
Your Team = ($500,000 USD):
- 3 Junior IT Developers $ 55,000 USD
- 2 Senior ID developer $90,000 USD
- 1 Senior Online marketing developer $75,000
- You as the owner of the company $80,000 (never pay yourself more than the average)
Office running costs (rent, phone, internet, utilities) = $ 110,000 USD
Total Costs: ($500,000+$110,000) x 1.5 years (18 months) = $ 915,000 USD
In other methods you can value your product and idea where these 2 other elements become part of the investment; Berkus method gives you the opportunity to come up with a sound idea or prototype and these 2 elements become part of the valuation. Scorecard Value Method also counts in the Product/Technology and Size of the Opportunity.
In this method you use the rule of 20% where 20% would be the margin if you sell your product.
Let us presume that the healthy margin is 20%. So if you work on any project or product and you expect to sell it, your added value should be marked up by 20%. This twenty percent is basically your extra value you bring to your project. Maybe the investor would ask why you use 20%. The simple answer is that we look at this as an expected profit. The previous 2 models are quite subjective but, this model will help you get your feet on the ground once you get challenged.
Total Estimated Revenue = Total Cost / (1-Margin%)
- Total Cost – $915,000
- Margin -20%
Total Estimated Revenue: $915,000 / (1-20%) = $1.14million
Next, Total (with your 20% margin) = Total Cost x Total Estimated Revenue
- $ 915,000 USD x 1.14 = $ 1,043,100 USD
We guess this is a great approach and you can always defend or explain why your valuation is set as it is. There is a good reason.
Now the question is, how much equity should you give up?
For a $1M seed round:
- A VC firm will look to get 10%-20%
- A group of angels/seed will look to get 15-25%.
It is a reality that other valuation methods are popular, however, it would be very difficult to defend the numbers if you are asked why you think that your idea is worth $500,000. It is much better to see how much money you need to build up a team including running costs. The 20% margin is also a great way to explain that this is the profit you should expect if you sell that project after 18 months.