Valuation Of Early-Stage Startups

To attract investors, startup founders need to carry out a detailed process of valuation that helps in making an informed decision for investors as well as for the startup

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Fundraising is an inevitable part of any startup journey. For creating a successful business story, startups need to go through several rounds of fundraising: pre-seed, seed and series rounds. In today’s scenario, fundraising fuels the operational growth of the business even in a highly saturated market. Inadequate funds may bring glitches in the journey of the business and make it challenging to survive in the market. Also, the paradigm shifts in the working models due to technological advancements and market uncertainties have complicated the survival of early-stage startups.

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In such a dynamic scenario, fundraising plays a crucial role in removing the glitches in the business operations. However, to attract investors, startup founders need to carry out a detailed process of valuation that helps in making an informed decision for investors as well as for the startup.

Understanding startup valuation

In order to receive funding from external sources such as angel investors, VCs, or a group of investors, startups need to figure out the total amount of capital they need. In simple terms, startup valuation works as a process to quantify the worth of the startup or startup idea. Startup valuation is one of the most significant parts of any fundraising process. While investing in a startup, investors exchange a part of the equity in the company. This is where the role of startup valuation comes into the picture. Fundamentally, the process of valuation removes the guesswork and presents the estimated value of the startup.

Usually, new founders lack knowledge of evaluating the startup. Some founders quote a high figure to the investors even when they are at the pre-revenue generation stage. Simultaneously, few founders quote a lower amount even if they have a winning idea and the potential to disrupt the market. Thus, imperative is to understand the key methods that are useful in the startup valuation process.

Startup valuation methods

Valuation methods are significant, especially for early-stage startups when they are at the pre-revenue stage. These startups usually do not have any hard facts or figures to base the value of the business. Hence, there comes the need of predefined valuation methods.

The prominent startup valuation methods are:

Berkus method: This method is one of the simplest, created by Dave Berkus,  an American venture capital expert.  This method assigns a value of $0.5 million to various factors as the startup begins to make progress. It describes five key factors: sound idea, prototype, quality of management team, strategic relationship, strategic partnerships, and product rollout or sales to determine the startup value in a range of $0-2.5 million. This method is only valid for pre-revenue companies.

Scorecard method: This method uses the valuation assigned to an already angel-funded company. It begins with finding a company of a similar stage operating in the same geography and same domain. After getting the average pre-money valuation of that company, the startup is thoroughly analyzed to find its strengths and weaknesses. It is given weightage to various factors such as the size of the opportunity, technology/ product, management strength, competitive environment, marketing, funding requirement, etc.

Risk factor summation method: This method works as a combination of the Berkus and Scorecard method while emphasizing the risk factors. Various types of risks associated with the investment are categorized to assign grades to each category. The major risk categories include management, stage of the business, sales and marketing risk, funding requirement, competition, technology, litigation, international, and reputation risk, and potential lucrative exit.

Venture capital method: This startup valuation method emphasizes the exit or the terminal value of the startup. In this method, the investors consider the expected future returns of the startup. It is one of the most effective methods which makes it is easier to estimate a potential exit value once certain target milestones are achieved.

First Chicago method: This method was first developed by and consequently named for, the venture capital arm of the First Chicago Bank. It is a business valuation approach used by venture capital and private equity investors. This method combines elements of both multiple based valuation and cashflow based methods, First Chicago helps the investors to understand how viable and ambitious the startup plan is. This method focuses on three different scenarios: best case, normal case and worst case.

Carrying out startup valuation, choosing the right method benefits the investor as well as the founder. It provides better knowledge of the company’s assets, resale value, and the true value of the company. It further helps at the time of mergers and acquisitions and raising funds to realize the future business plans and goals of the company.