How is a startup company valued?

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The question of how to do valuation of a pre-funding startup is one all entrepreneurs face early in their career.

Getting the pre-money valuation seed stage right is crucial if you are to attract investors, raise the amount of finance you need, and sell off equity at a reasonable price.

There is a conflict of interest between how to value a business for investors and entrepreneurs, as investors will want to buy in at the lowest price possible. In contrast, the business owner will hope to raise as much finance as possible for the least amount of equity.

Because of this, there are different ways to establish the market value of a startup company, and the method you choose could have a significant impact on the calculated valuation.

At the same time, some universal truths will always influence the value of your business.

By understanding the universal factors and choosing the best method for your business valuation, you can stand yourself in good stead when reaching out to potential investors during your seed finance stage and beyond.

What affects valuation?

Many factors can affect the valuation of a startup business. If you are not yet trading, it's not as simple as just adding together the values of your order book, assets, and intellectual property.

For new businesses, valuations are more of a forecast than a measure of present-time net worth.

Investors will expect your valuation to be accurate and rigorously calculated. They might also expect you to include estimates of risk, as well as margins for error and confidence intervals.

As an entrepreneur, your priorities may include maximizing the valuation as far as possible and keeping hold of your equity. Retaining equity, in turn, means you will save more of your future profits, as you won't have to pay out so much in shareholder dividends.

Early fundraising will also influence later investment rounds. So for example, if you used a large amount of pre-seed funding from friends and family to set up your business, professional investors at the seed stage will see this as a higher amount of debt that your company needs to pay back before it becomes profitable.

Analyze your balance sheet

One way to get a clearer idea of your startup valuation is to analyze your cash flow. Work out any income or revenues your company is already generating, if you have already launched.

Calculate your total monthly spend on all business costs, including workforce, premises, supply chain costs, utilities, professional fees, transport and everything else. Leave nothing out.

The net loss after subtracting these costs is your monthly burn rate. It tells you how much you'll need investors to put in if your business is going to survive until it becomes profitable.

Allow for at least 12 to 18 months before you need any more external investment. This gives your company some time to grow, so you can revise your valuation and still have time to reach out to investors.

Although your burn rate is not the same as your company's value, it tells you how much you need to raise. You can then look realistically at ways to evaluate your business and whether the result you get from your chosen method is more, less or roughly equal to your burn rate.

Take a look through future performance projections

Projections of future performance always carry some doubt, but they can still be an excellent way to predict what your company's valuation will be at some future point in time.

Try to factor in all of the different influences on your cash flow, including overheads, spending, revenues and profits.

Be realistic about the growth rate you will achieve. Investors will want to see achievable projections, so don't be tempted to artificially inflate your valuation by predicting faster growth unless you have convincing evidence for doing so.

At the same time, don't undervalue your business or you risk selling off equity too cheaply.

Some investors will only consider opportunities if the company valuation is over a specific size, so accurately forecasting your growth could be one way to unlock interest from these high wealth individuals and institutions.

If you're not sure what to expect from your business once it launches in full, try to look at similar companies in your chosen industry or local area.

Many will have publicly available financial statements, shareholder dividend reports, and so on. Check the investor relations page of their website, if they have one, and compare performance over several fiscal years or quarters.

Exploring the many different methods of evaluations

When learning how to value a small business for investors, you might be surprised by how many different methods entrepreneurs use.

The different business valuation methods a startup business depend on what information is already known, such as the value of any tangible assets that belong to the business or cash flow projections based on orders already received.

If precise information is not available at the pre-money valuation seed stage, then the valuation may instead be based on forecasts, an assessment of risk factors, or a comparison with a similar company that already exists.

As an example, here are nine different ways to do valuation of a pre-funding startup:

  • Valuation based on 12 risk factors (risk factor summation)
  • Valuation based on five success factors (Berkus method)
  • Valuation based on an average of three scenarios (First Chicago)
  • Valuation based on KPI from a similar company (comparable transactions)
  • Valuation based on the weighted average value of a similar company (scorecard)
  • Valuation based on the value of tangible assets (book value)
  • Valuation based on the scrap value of assets (liquidation value)
  • Valuation based on future cash flow (discounted cash flow)
  • Valuation based on investors' expected ROI (venture capital)

Whichever method you decide to use, remember that they all only provide you with an estimated value for your business at some point in the future.

Only once your company is up and running will you have a clear idea of what it is worth, based on your profit and loss and your cash flow position at any one time.

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