START-UP VALUATION TECHNIQUES FOR SEED-STAGE COMPANY
Overview:
Raising funds is an inevitable component of any startup’s journey, and entrepreneurs must go through multiple rounds of capital raising, which are pre-seed, seed, and series rounds, to establish a successful organization.
When it comes to the seed stage, the timing of getting financing and the exact amount needed are essential. Businesses must first establish the amount of seed funding required before pursuing any of the above-mentioned external sources. This is when the seed funding valuation comes into play.
What Is Startup Valuation?
In layman’s terms, startup valuation is the process of estimating a company’s worth. During the seed fundraising round, an investor invests money in a business in exchange for a part of the equity in the company. This is why valuation is crucial for entrepreneurs since it helps them determine how much equity to provide to seed investors in return for funding.
It is also critical for an investor to understand how much company share they will receive in exchange for the money committed during the startup stage. So, in essence, startup valuation can be a deal maker or a deal-breaker. Knowing the business value and its determinants is critical for startup valuation decision-making.
Factors Affecting the Valuation For Startups At Seed Stage
There are several factors that influence the valuation of a company:
- Traction: This is one of the major factors that impact the valuation for the seed stage. Principally the quantitative proof of customer demand, , traction demonstrates development and growth, which is why it is the most important aspect that convinces investors to invest money in a company.
- Reputation: Founders need to ensure a positive image in the market. One of the most important things that an investor looks at before investing is the founder’s capabilities.
- Prototype: The development of a prototype is a major factor that can influence the decision of an investor. So, before planning to pitch to an investor, make sure the prototype is ready.
- Pre-valuation Revenues: Undoubtedly, revenues are important for any company as they make it easier for investors to carry out the valuation. So, if a product has hit the market and is already generating revenue, it could sway the investor’s decision in the favour of that startup, and prove to be a real deal sealer.
- Distribution Channel: In the initial stages of any startup, it is very likely that the product/service will be in preliminary stages too. Hence, founders need to be careful about the distribution channel that is being used, as it can have a direct impact on the valuation.
- Industry Analysis/Market Size: If the startup belongs to a booming industry, it is highly likely that investors will pay a premium. This implies that it is important to choose the right sector as it will increase the worth of a business enterprise. Also, the market size of the industry becomes an important criterion going after.
Start-Up Valuation Techniques for Seed Stage Company
- Scorecard Valuation Method
This method is used to compare the target firm to other seed-stage companies to determine the company’s value to create a pre-money valuation.
The target firm is the one that needs funds or where money will be invested. A comparable firm is a recently funded company or any startup in the same market, area, or sector at the same stage. As a result, once these investors have determined the average valuation price of comparable companies. Then, investors analyze aspects such as managerial strength, marketing and sales, growth potential, product and technology, and compare the target company to other firms. In the company’s valuation process, each factor is assigned a defined weight based on its worth and the sum of weight should be 100%.
| Figure 1: Scorecard Valuation Method | ||||||||||||||||||||||||||||||||||||
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“This method compares the target company to typical angel-funded startup ventures and adjusts the average valuation of recently funded companies in the region to establish a pre-money valuation of the target”
- Berkus Method
It is also another valuation method for early-stage companies. It doesn’t rely upon the company’s forecasted revenues or the forecasted financials. The Berkus method studies the crucial areas of the company and indicates a value ranging from each area.
In this method Investors Value the major elements of the Seed stage company.
- Sound idea: investors value the business idea and scope for the idea.
- Quality management team: Investors value the execution of the management and their strategic plans.
- Prototype: Valuation of the products and their business model.
- Strategic relationship: Valuation of the partnerships of the company and the relations with customers and suppliers of the company.
- Product rollout or sales: It is an assessment of a startup’s capacity to market and sell its product.
After adding all the Values from all five areas. The pre-money valuation derives. There are five areas, With a maximum range of USD 0 to USD 500,000. which laid the theoretical maximum pre-money valuation to USD 2.5 million. The Berkus Method is a simple model that is primarily dependent on qualitative factors. As a result, it is a traditional method of valuing pre-revenue firms. The method generates an approximate valuation estimate.
- Cost-to-Duplicate
Investors use this valuation strategy to estimate how much it will cost to start a similar firm from scratch. As a result, investors will focus on the significant costs of startup-like research expenses, Loan fees, licensing permit fees, technology charges, equipment and supplies, and then advertising and marketing costs. If the cost of replicating the startup is low, the startup’s value will be low. If it is expensive and difficult to duplicate, then the valuation will be higher. The main disadvantage of this technique is that it does not reflect the intangible value of the company or its future potential. The company’s growth, as well as characteristics such as its client retention power.
- Comparable Transaction Method/ Market Multiple
The valuation occurs in this technique based on actual market prices and transactions that occurred at companies of a similar size, revenue range, industry, and business model to see what they were valued at or sold for. Indicators for comparison could be monthly recurring revenue, weekly active users, profit & loss, sales, gross margin, EBITDA, and so on. However, that comparable comparison is difficult to discover in the startup market. This strategy may be most effective when comparing two startups that produce similar products or provide equivalent services.
| Figure 2: The Comparable Transaction Model | |||||||||||||||||||||||||||||||||||||||||||||||||
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The rule of three is used in this approach. It is successful to retrieve a reliable indicator for comparison in order to determine the startup value. This may include recurring monthly revenue, weekly active users, sales, gross margin, EBITDA, and so on. The problem is that it’s challenging to locate exact equivalents in the startup market.
- Discounted Cash Flow
DCF method is based on future performance. It estimates how much cash flow a startup can bring out & discounting them at a certain rate of investment or the “discount rate.” The higher the discount rate, the more risky the investment will be.
We can’t use the DCF method in startups with negative earnings. because it is hard to predict the future cash inflows. In short, we can say DCF analysis aims to determine the current value of an investment based on projected returns.
- Calculation of the DCF Value:
Here, CF= Cash Flow, DCF= Discounted Cash Flow & r= Discount rate.
- Valuation based on EBITDA Multiple
EBITDA: earnings before interest, tax, depreciation, and amortization.
The major factor evaluated by investors is that a firm should present a simple, measurable indication of the profitability of an investment, EBITDA paints an accurate picture of the company’s status. The formula for enterprise value is EBITDA into EBITDA multiple.
- Investors use the following formula for startup valuation using EBTIDA:
- Venture Capital Method
The technique starts with estimated future revenue and represents the investor’s expectation of a corporate exit in a few years. It computes pre-money valuation by first calculating post-money valuation. The Venture Capital approach is frequently employed in valuations of pre-revenue enterprises where estimating a possible exit value is easier.
The method has several pre-money valuation formulae.
- Calculating the Terminal Value: Terminal Value is the estimation value of the startup on a specific future date. The formula has the following three requirements:
- Calculating Pre-Money Valuation: For, Pre-money valuation we require two things- Desired Return on Investment by Investors and the Amount of Investment.
Here, Terminal Value is the origination’s estimated value on a certain future date. The return on investment can be assessed by assessing what return an investor could expect from that investment given the level of risk.
- Risk Factor Summation Method
This method is ideal for early-stage startups looking to establish pre-money valuation.
The Risk factor summation method assigns a value to the company based on the starting point of a similar startup. This baseline value is then adjusted for common startup risk variables ranging from extremely low to very high. Lower risks improve your company’s valuation, whereas bigger risks diminish it. One might try to focus on the risks and establish plans to cover or lessen them to increase the valuation.
These are 12 standard risk factors under this method:
| Figure 3: Risk Factor Summation Model | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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- Book Value Valuation Method
Book value valuation is a simple startup valuation technique because it is derived by subtracting the value of intangible assets and liabilities out of the total value of tangible assets. This method is often not adapted for startup valuation because it considers only tangible assets, while startups are more concerned with intangibles such as patents, copyrights, and so on.
Book Value = Total Assets – Total liabilities
Conclusion:
At the seed stage, there is no single way of calculating startup valuation. Every company or industry in which the startup operates is distinct and has its own set of requirements. Thus, a combination of various methods is the most favorable choice.
Finally, the value of the startup is what investors are willing to invest in. Before investing, investors investigate market dynamics, comparable deals, and recent exits.
