Whether you’re an entrepreneur with a startup to sell or a buyer in the market for acquisitions, determining the valuation of a startup is a necessary first step before entering negotiations.
At NorthStar Venture Partners, we work with startup owners and buyers every day. One of the most common questions we get asked is this:
What method should I use for the valuation of a startup?
We love this question because it gets at the heart of what we do. Here are 5 methods you can use to determine the valuation of a startup.
#1: Berkus Method
The Berkus Method is useful for valuation of startups because it assigns dollar values to the progress a startup has made to get their business off the ground. Here are the things that add value to a startup:
- A sound idea -- adds up to $500,000 of value
- A completed prototype -- adds up to $500,000 of value by reducing technology risk
- A quality management team -- adds up to $500,000 of value by reducing execution risk
- Strategic relationships -- add up to $500,000 of value by reducing market risk
- Product rollout or sales -- adds up to $500,000 of value by reducing production risk
As you can see, the Berkus Method prioritizes the reduction of risk, adding value for each element a startup has that can reduce risk and increase the chance that a buyer will get a good return on their investment. Keep in mind that you can assign partial value. For example, if a startup has completed 50% of the work on a prototype, you could add $250,000 of value instead of the full $500,000.
#2: Scorecard Valuation Method
Our next method is the Scorecard Valuation Method, which evaluates a startup by comparing it to the average pre-money value of other startups in the same sector. Then, you would use the scorecard to arrive at the correct value.
Here are the elements of the scorecard:
- Strength of the management team - 0% to 30%
- Size of the opportunity - 0% to 25%
- Product/technology - 0% to 25%
- Competitive Environment - 0% to 10%
- Marketing/Sales Channels/Partnerships - 0% to 10%
- Need for Additional Investment - 0% to 5%
- Other Factors - 0% to 5%
What we like about this method is that it allows for some flexibility in startup valuation by using a range of percentages. Not every startup is the same and this method can give you the freedom to give more weight to a startup’s most important assets.
#3: Venture Capital Method
The Venture Capital Method focuses on the ROI of an investor’s money to arrive at a pre-cash value of the startup in question. Here’s how it works.
The basic formulas are:
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-Money Valuation; or Post-Money Valuation = Terminal Value ÷ ROI
So, if the startup had a terminal value of $2 million and an anticipated ROI of 20X, and needed $50,000 to get off the ground, the formula would be:
$2,000,000 ÷ 20X = $100,000 (Post-Money Valuation)
$100,000 - $50,000 - $50,000 (Pre-Money Valuation)
This method is useful if you have an investor who is specifying a desired ROI as a condition of selling the company.
#4: Cost to Duplicate Method
The Cost to Duplicate Method is the valuation method that requires the most due diligence. It works by estimating, as closely as possible, the amount it would cost to duplicate the startup as it is at the time of valuation.
This method requires extensive research, but it offers one of the most realistic valuation methods because it takes everything into consideration, from the initial idea to labor to relationship-building.
The downside of this method for startups in the early stages of development is that unless you have a structure or model that’s very difficult to duplicate, your company is likely to have a low value. On the other hand, a startup with a unique model and product could be worth a great deal even in its early stages.
#5: Valuation by Multiples Method
Our final method is best for startups that already have their feet under them. It begins with the startup’s EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
A buyer might use a multiple of your EBITDA to determine the startup’s value, adjusting the multiple according to your:
- Management Team
- Other qualitative aspects of your business
The multiple used may vary greatly from startup to startup, but we’ve seen this method used to offer a price of 5, 10, or even 15 times the EBITDA. Again, this method is not suitable for early-stage startups, but for those with some maturity and a proven business model.
Startup valuation can be complicated, but the 5 methods we’ve listed here are among the most common and can help get you started, whether you want to estimate the value of your own startup or acquire a startup as a growth strategy.
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