Startup Valuation 101: 9 Valution Methods And How They Work

India is now the third-largest startup ecosystem in the world. The Indian government has made commendable efforts to achieve this milestone by launching a number of initiatives to promote and support entrepreneurs.

Startups are no longer just an important part of the Indian economy; they are also a significant source of much-needed foreign direct investment. In 2021, the government recognised 14,000 new startups, with 44 of them becoming unicorns (having a valuation of $1 Bn or more).

Every startup in its journey requires funding assistance, and the biggest question they face is “HOW?” Should they seek angel investors, venture capitalists, or bootstrap their business? To answer this question, the startup will need to figure out its pre-money and post-money valuations. 

Simply put, pre-money is the value of a company before an investment, while post-money is the estimated value of a firm after an investment.

While various valuation methods exist, Discounted Cash Flow (DCF) is the most commonly used. As an investment banker, I am frequently asked if this is the only method of valuing a startup, so let me try to answer this question.

Let us look at the various startup valuation methods and when they are best suited.

Discounted Cash Flow Model (DCF)

Discounted cash flow estimates the value of an investment based on its future cash flow. The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF. If the DCF value is greater than the current investment cost, the returns are positive, and vice versa. 

DCF analysis is used to assess an investor’s returns in terms of the time value of money. This method is suitable where cash flow is predictable. For a business with a burning model or negative revenue, the DCF method may not be the right choice.

Venture Capital Method (VCM)

Venture Capital Method is the second most used method. It is ideal for a startup in its early stages or a company that has yet to generate revenue.

The first step is to determine the terminal value of your startup and estimate the exit multiple. An exit multiple is one of the methods that is used to calculate the terminal value in the discounted cash flow formula. 

Next, calculate the expected ROI. Divide the exit value by ROI to arrive at your post-money valuation. To calculate your pre-money worth, subtract the investment amount you’re looking for from this figure. To achieve the terminal value, you will need to invest the pre-money valuation today.

The First Chicago Method (FCM)

The First Chicago Method is ideal for a company with dynamic growth. It focuses on post-money valuation. An early-stage startup lacks historical data to forecast potential growth. As a result, there is a good chance that the predicted growth will differ from the actual growth.

The best way to forecast a startup’s future growth is to consider all possibilities, including the best, base, and worst scenarios. The first step in each of these scenarios is to calculate valuation using either the DCF or venture capital methods.

Next, assign a probability to each scenario and compute the weighted average valuation by multiplying the probabilities by the valuation for each situation (best, base, and worst).

The advantage of FCM over DCF and VCM is that it improves management flexibility, which DCF and VCM fail to do.

Real Option Method

The Real Option Method is an addition to DCF rather than an alternative. It requires one to conduct a DCF before embarking on option pricing.  The discounted cash flow method is often used to calculate the asset’s value.

Occasionally, an asset may be undervalued due to the option to delay, expand, or abandon it.

While DCF and VCM are good options, real option pricing comes into play when exploring certain situations is impossible due to uncertainty.

For Real Option Pricing, one needs first to calculate DCF by ignoring the option, do a qualitative assessment of the option, prepare a decision tree analysis and estimate the value of the real option.

Relative Valuation

Relative valuation assigns a value to a company based on similar companies or companies with similar characteristics. The first step here is to identify peers with similar traits. 

Next, look for relevant multiples such as EV/EBITA, P/E ratio, EV/Revenue, and EV/EBIT, among others. Once you have the numbers, multiply them by the mean or median of the multiples to get the value. It helps investors: 

• Screen and shortlist stocks to develop a consideration set for new investments.
• Determine whether an existing investment is overvalued compared to its peers and should be disposed off. 

Relative valuation can be done in two ways:

• Comparable Company Method: The current share prices of similar companies on the market are used to calculate a startup’s value. 
• Precedent Transaction Method: The price paid for comparable companies in the past is used to estimate a company’s value.

Decision Tree Approach

Management frequently uses decision tree models because they graphically present information along with the possible probability of the final outcome. A decision tree is a kind of flowchart.

To begin, write your decision in a small square on the left side of the page. Then, draw conclusions on the right side by drawing lines from the decision square for each feasible option. Assigning estimated numeric values to each outcome will help you make the right decision.  All possible outcomes must be listed, along with the associated revenue or loss.

This method helps businesses project possible outcomes in order to make informed and well-thought-out decisions. It helps businesses tackle various problems across industries, from technology to healthcare to financial planning.

Berkus Valuation Method

One of the biggest challenges that an early-stage company seeking valuation faces is calculating the revenue numbers or comparing its product to products available in the marketplace that appear similar but are not.

The Berkus Method finds the answer by manoeuvring the problem. It assesses five different elements to quantify the qualitative factors used to evaluate the company — base value, technology, execution of strategic relationships, production, and sales.

Each of these elements is given a monetary value. Adding them up gives the valuation of the company. The values of elements can be updated and adjusted on a regular basis to reflect modern market dynamics.

Risk Factor Summation Method

As the name implies, Risk Factor Summation (RFS) anticipates all workable risks associated with the business that can have an impact on Return on Investment.

It bases the target company’s valuation on the base value of a comparable startup. The base value is adjusted for 12 common risk factors, such as management, politics, technology, and competition, among others.

This method entails comparing your startup to other startups in order to determine whether your startup is more or less risky.

Scorecard Method

Scorecards are widely used by angel investors to value startups. This method uses a weighted average value that has been adjusted for a comparable company. Weights are assigned to various factors that are comparable to other companies in similar industries, geographical regions, and stages of development.

The scorecard valuation method comes in handy when seed valuation is too low and shows that investors and entrepreneurs have overvalued financial contributions and that the chances of an early-stage startup diluting are higher.

Investment bankers may use one or more of these methods to determine the value of your startup.  Understanding these methods should give you a better understanding of the approach being used.  Remember that the valuation of any business is based on the forecasted numbers.  Valuation is subjective and hence often debatable.