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How to valuate a startup can be quite different from how to determine the value of other companies. Unlike valuations for established businesses, startup valuations are calculated largely based on potential, not the companies’ current financials.
Whether you’re looking for funding or financing – or if you just want to know what the business is worth – there are several valuation methods to choose from. Learn about four of the most frequently-used strategies, plus common mistakes to avoid – before you start looking for outside capital.
Key Points
• A startup valuation helps price equity when you’re in the market for angel investors.
• When you’re looking at how to valuate a startup, you have several options to choose from: The Berkus, scorecard, and VC methods all take growth potential into account.
• The cost-to-duplicate method is a more conservative valuation method than many others but easier to calculate.
• When you’re valuing a startup, it may be tempting to overvalue or undervalue, but accuracy is crucial.
What Is Startup Valuation?
A startup valuation estimates the worth of a company that’s in its early stages. If you have an early-stage business, instead of applying for a startup loan, you can assign a dollar amount to your business, then look for investors to give you capital in exchange for equity. When you accept an investment amount, the investor typically gets the percentage of the business that money represents compared to the business’s total value. So if a startup is valued at $1 million and receives a $200,000 investment, the investor would receive 20% equity (ownership) in the company.
Why Startup Valuation Matters
Startup valuation is key for getting funding if you don’t want to take out a small business loan. So it’s a process that deserves some thought and care.
While you might assume that a higher valuation is automatically better, in point of fact it’s important to be as accurate as possible. Overvaluing a startup company during an early round of fundraising could make it harder to justify an even higher valuation during a future funding round and can be especially problematic if the valuation decreases.
Undervaluing your startup, on the other hand, can mean you have to give up more equity to early-stage investors in order to raise the same amount of capital. That’s why it’s generally a good idea to be as realistic as possible, no matter what your current investment goals are.
Common Startup Valuation Methods
There are four primary methods for valuing a startup company. Explore each one to see which makes the most sense for your business.
Berkus Method
This framework is a pre-revenue business valuation method focusing on five success factors:
• Basic value of the concept or market potential
• The service, technology, or prototype’s current stage of development
• Execution, including the background and experience of the founders
• Strategic relationships, such as advisors, partnerships, or other industry connections
• Expected timing and progress toward production, market entry, and sales
Then a monetary value of up to $500,000 is assigned to each category, with a total potential value of $2.5 million.
This method is primarily used for early-stage companies with little to no sales that are seeking an angel investor. While it may feel limiting because of the dollar caps in each category, it can be a good strategy to use if you don’t have financial projections yet.
Scorecard Method
As the name implies, the scorecard method values your company by comparing it to other similar startups in your region and industry.
The first step is to average out the pre-money valuation of those similar startups. This is the benchmark figure that will be used to value your startup.
From there, you score the company’s potential based on seven categories, each of which is weighted (and potential investors may adjust the system to fit their preferences).
• Management team (25%)
• Opportunity size/timing (15%)
• Product or technology (15%)
• Marketing and sales strategy (10%)
• Competitive environment (10%)
• Need for funding (10%)
• Various other factors (15%)
A score of 100% in a category means that that attribute is on par with other similar startups looking for seed funding. Anything above or below 100% shows whether your company is above or below average.
Next you multiply each category score by its assigned weight; then add all those totals together to get a sum of factors. Finally, multiply the sum total by the original average valuation to get your startup’s estimated value.
Venture Capital Method
The venture capital (VC) method is another valuation strategy for early-stage startups looking for seed or pre-seed funding. It involves six core steps that are a little more in depth than the previous two methods.
• Estimate the amount of capital needed for specific goals
• Create a financial projection for the investment
• Predict an exit timeline for the startup
• Estimate the company’s exit value based on industry comps
• Use a discount rate on the exit value to calculate the present value
• Determine pre-money and post-money valuations, making any adjustments before finalizing the valuation
Cost-to-Duplicate Method
The cost-to-duplicate method is more straightforward and conservative than some of the other options. It simply calculates what it would cost to develop the company and its product or technology all over again. (This applies only to physical assets, not intangible assets.)
The downside with the cost-to-duplicate method is that it doesn’t account for any future growth opportunities. Some may say that makes it more realistic because you’re only using hard numbers to create the valuation. But it could also overly suppress your valuation, especially if you have strong intangible assets that aren’t factored into the final number.
Key Factors That Influence Startup Valuation
Each startup valuation method has its own set of factors that are considered in its calculation. But no matter which method you choose, you’ll need to look at both company-specific and market factors, whether you’re trying to attract investors.
Some of the most important inputs related to the company itself may include its brand, technology, product, leadership team, intellectual property (IP), and location. From an industry perspective, you will likely need to consider factors like market size, competitive and regulatory landscape, growth potential, and other startup comps.
Common Startup Valuation Mistakes to Avoid
As you learn how to value a startup, avoid these common mistakes that can impact those final numbers and investor interest.
• Not accounting for founder deadlocks: A 50/50 split between two owners may seem fair, but you need tie-breaking mechanisms in place in case you don’t agree on valuation or investment decisions. Poor governance can increase the perception of risk.
• Skipping founder vesting: Vesting founder equity to unlock over a period of time ensures each founder either continues to contribute to the company’s success or forfeits unvested shares if they decide to leave.
• Not truly owning company IP: Whether you start your company while working at another job with a strict IP ownership contract or outsource some work without getting the IP assigned to your company, this mistake can tank your valuation.
• Not using GAAP accounting standards: You must use proper revenue recognition practices in order to accurately portray your financials. One common mistake is counting an annual subscription payment as revenue for the month; in GAAP accounting, it must be spread out over the entire service period.
Recommended: What Is a 409A Valuation?
The Takeaway
Understanding startup valuations is a must when you’re preparing to take on any kind of funding or financing for your new company. Choose the method that makes the most sense for your business model and development stage, then start exploring your options.
Ready to grow your business? SoFi Small Business Loans can give you fast access to the capital you need. Check your eligibility in minutes.
FAQ
What is a good valuation for a startup?
A good valuation for a startup is an accurate one. Accuracy helps ensure that you can justify the number to potential investors, but also that you don’t give away too much equity with an undervalued estimate.
How do investors determine startup valuation?
There are several different startup valuation methods, including the Berkus method, the scorecard method, the cost-to-duplicate method, and the venture capital method.
What is the difference between pre-money and post-money valuation?
A pre-money valuation is the estimated value of the startup before it receives any external investment. The post-money valuation is how much that startup is expected to be worth once the funding round is complete.
At what stage is a startup valued?
A startup is usually valued when it’s ready to raise capital from investors either through a pre-seed or seed round of funding.
How does equity dilution affect startup valuation?
Equity dilution reduces the owner’s existing stake in the company, often to attract new investors for funding. It can help bring in more capital to the company, which could improve its long-term valuation. But it also reduces the original owner’s profit share.
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