Start-ups are new companies founded to address a problem, fulfill a demand, or bring a unique product or service to market. Initial funding to launch the business usually comes from company founders and the founders’ friends and family. To expand, grow, and mature, start-ups raise more capital from other sources like venture capitalists and strategic investors.
To determine how much money it needs, a founder must accurately know the start-up’s current value. Learning how to increase your start-up’s value will allow you to raise more funds to take the company to the next level (IPO).
Lots of start-ups fail, primarily due to a lack of funds. Many entrepreneurs think of raising money as a necessary evil, but it becomes part of your regular workflow if you think about it as part and parcel of creating or growing a start-up.
To learn how to grow your start-up’s value, you must first be familiar with the standard valuation methods for start-ups.
Start-up Valuation Methods
The following six methods are most commonly used to determine the value of start-up companies.
1. Venture Capital Method
The venture capital method helps value early-stage, pre-revenue start-ups. The idea behind this method is that when an exit (a liquidity event) occurs, the investors who expect a particular rate of return on their investments may realize their investment returns.
Expected Return on Investment (ROI) = Exit Value or Terminal Value ÷ Post-Money Valuation
Post-Money Valuation = Exit Value or Terminal Value ÷ Expected Return on Investment (ROI)
Exit value or terminal value is the estimated selling price for the start-up. It is calculated as a multiple of revenues the company earns the year it is sold. For example, investors expect company XYZ to generate revenues of $10 million in the year of the sale and assume the sales multiple of three. The anticipated exit value is $30 million.
The rate of ROI, usually a multiple of the investment, is a function of the risk perceived by the investors. As start-ups are risky, the targeted ROI for early-stage companies is often high, such as 8X or 10X.
So, considering the above example:
$30 million Exit Value or Terminal Value ÷ 10 Expected ROI = $3 million Post-Money Valuation
Suppose the investor invested $5 million, the pre-money valuation is calculated as invested capital less post-money valuation.
$5 Million Invested Capital – $3 million Post-Money Valuation = $2 million Pre-Money Valuation
2. Cost to Duplicate Method
The concept behind the cost-to-duplicate method is figuring out how much it will cost to recreate your start-up. Add the fair value of all physical assets, research and development costs, prototype costs, and other expenses needed to start your business from scratch.
The drawback to this method is that it ignores elements like customer engagement and intangible assets like revenue, future potential, brand, or goodwill.
3. Berkus Method
The Berkus method, formulated by super angel investor Dave Burkus bases the calculation of start-up valuation on five elements, using qualitative and quantitative factors:
- Sound idea (primary value with acceptable risk)
- Prototype (reduces technology risk)
- Quality management team (reduces execution risk)
- Strategic relationships (reduces market or competitive risk)
- Product rollout or sales (reduces production risk).
This method assigns a monetary value up to $500,000 to each of the five elements and caps pre-money valuations at $2 million and post-money evaluations at $2.5 million.
Also, the method sets the target deemed achievable in five years (aka, the “hurdle number”) at $20 million in the fifth year of business. That means revenue is expected to reach $20 million by the fifth year and the investment to increase ten times in value.
The Berkus method is most suitable for the valuation of tech start-ups but does not consider the market.
4. Discounted Cash Flow Method
The discounted cash flow method of start-up valuation attempts to determine its current value based on its estimated future cash flows and apply a specific discount rate. One drawback: this method relies on assumptions that could be inaccurate.
5. Comparables Method
The comparables method uses comparisons: i.e., how much are investors paying for start-ups like mine?
Find companies comparable to your start-up and their valuations. Compare the similarities and leave out differences. Factor in ratios or multiples for the differences. For example, if another company has proprietary technology that you do not, lower the multiple accordingly to value yours.
The valuation by multiples method helps value more mature start-ups that are showing profits. Suppose your start-up is generating an EBITDA of $300,000. An investor could value your business multiple times commensurate with your industry, competition, management, growth, etc.
Start-up Business Stages
The methods above also depend on your company’s stage of business. Start-ups generally have three stages:
- Seed stage
- Round A stage
- Round B stage.
Seed Stage. This earliest stage in the start-up’s lifecycle consists of an idea. The business, team, assets, and revenue do not yet exist–the venture capital or the Berkus methods best suit the valuation of start-ups at this stage.
Round A Stage. At this stage, the start-up has advanced from a solid idea to a prototype or a beta product and has already made some sales. Use the venture capital or cost to duplicate methods to value your start-up at this stage.
Round B Stage. When your start-up reaches the Round B stage, you have proven your business model and need funds to grow further while expanding your company. It is possible to estimate your business’s potential revenue generation capacity at this stage so that you can use discounted cash flow or valuation by multiples methods for your start-up valuation.
Start-ups can be risky, so it is essential to growing value quickly to attract investors and higher multiples.
It’s all very well and good to know how to value your start-up, but to get the best valuation, you must know how to increase the company’s value. We recommend these five tactics.
1. Competitive Advantage
Innovate and build something unique to obtain a competitive edge in the market. Obtain patents, copyrights, and trade secrets to defend what makes your company unique and safeguard against copycats.
Use strategic marketing to position your product or service as the leader in your market niche. Defend that advantage by restricting competition from entering the market if you can.
For example, the plant-based meat producer Beyond Meat saw its valuation drop due to growing competitors and a low entry barrier into the market.
2. Immense Market Growth Potential
The market in which your company operates impacts its growth. Identify how large the market is now versus how large the market will be in the future.
Seek a market with a CAGR (compound annual growth rate) of over 8 percent. Such a fast-growing market uplifts the revenue of even an average product. So, getting into a fast-growing market is key to the growing value of your start-up.
3. Boost Perceived Value
Perceived value differs from real value, as it relies on psychological factors. Perception is everything. For example, the dot-com bubble was driven mainly by the fear of missing out. Build your reputation in the media and industry, but be careful not to over-promise and under-deliver.
4. Accelerate Growth
Open growth pathways by focusing on revenue growth. Being able to grow, change, and adapt is what makes start-ups valuable. Capitalize on your agility by making your start-up scalable by automating processes, adopting technology-driven solutions, enhancing your business model, and measuring your company’s scalability for further improvement.
5. Capitalize on Predictable Revenue
Start-ups are risky enough, so you make sure your product is “sticky” to grow future revenue with a product/pricing structure that leads to repeated sales. Focus on obtaining recurring business from your customers, tap on upselling and cross-selling opportunities, consider a subscription-based business model, and keep the churn rate low.
Grow Value, Measure It Accurately
To acquire funding for your start-up, you’ll have to exchange interest in your company with investors. To ensure you don’t give away more interest than you should, you now know both how to value your start-up accurately and how to increase its value.