“We just assessed our current runway. And, it looks alarming. Looks like we have to raise funds sooner than we had anticipated. We have to ramp up our fundraising activities on war footing and raise the money we need within the next 90 days. The clock is ticking!”

“We need to expand our operations and hire more skilled talent. We have to invest on product innovation and market outreach. We need more funds otherwise we may survive for a while but may not sustain for long because if we don’t innovate now then sooner or later the competition will eventually catch up. We can’t just pass on our competitive edge.”

Do these scenarios and statements seem familiar? Well, I suppose most entrepreneurs have gone through similar situations, had similar thoughts and uttered similar words at some point or the other during the course of their entrepreneurial journey. The truth is, a founder’s life is a glorified bed of thorns, the glitz and the glamour shine only on the outer shell. While deep within it’s a hard fight; to survive, to sustain, and to make things happen; all the time, every time; at the same time, it is also a highly rewarding an experience. However, we only know about the startups who steal the limelight and make the cut, but then there are those which don’t. And, availability of funds is one of the top reasons to influence that outcome.

The truth is, a founder’s life is a glorified bed of thorns, the glitz and the glamour shine only on the outer shell.

As per data, about 50-90% of startups fail within the 5-10 years of incorporation out of which 29% of startups fail due to lack of funds or in simple words, they just run out of money. From a global standpoint, only about a 0.05% of start-ups manage to get VC funding. As mindboggling as they are, these stats show a hard fact, that just a great idea is not going to cut it, you need fund to execute that idea to the best of your ability and best alignment to your perceived vision delivering maximum value for your current or potential customers at every stage of your startup.

Unless you want to build a bootstrapped success story with your own fund, you need to know and do what a fund seeking or a funded venture would. As they say, as a new Founder while you keep your eyes on the moon you must place your feet firmly on the ground. Because when it comes to fundraising and growing your venture your best will be tested. Reason why fundraising is positioned right there on top of every founder’s wish list and is one of the most (if not the most) critical success factors for startups. While fundraising may not be just a walk in the park, the process can be made more adaptable by gaining the right knowledge and taking the right action.

So, if the questions on top of your mind are; how does the valuation work? How will the investor assess my start-up? How do we raise money? etc., then you are probably reading the right article. Meanwhile, I would also like to recommend you reading my earlier post on ‘The 7Ps Framework of Fundraising’ which is built upon a foundational model to apply in your fundraising journey.

It is fathomable that navigating the world of startup fundraising can be daunting for most founders, especially new entrepreneurs. However, as you might have figured by now that understanding how investors will assess the worth of your startup is crucial for positioning your business effectively for fundraising. In this article I’ve tried to draw out an outline on startup valuation methodologies with meaningful insights into what investors look for at different stages of a startup's lifecycle. I’ve tried to keep the content as jargon free as possible to help you with only what you must know and need to know. For additional reference, you are more than welcome to do further study into any of the topics mentioned in this blog. Feel free to write in with your requests and suggestions on topics of your interest that you would want me to write on next.

Now, let’s take a look at some of the basic know-hows of how startup valuation is done and what really goes into assessing a startup and then why one startup is selected over the other. Let’s start with the basics first.

How startup valuation is calculated? Basics of Valuation.

When it comes to startup valuation there are umpteen number of models, frameworks and formula that are used to evaluate and assess a startup, an idea or a concept. It is beyond the scope of this article to cover each of them. However, as a quick reference I’ve listed out a few of the popular methods here. These are some of the preferred ways that an investor evaluates a startup to determine its fund worthiness.

Discounted Cash Flow (DCF) Method

The DCF method involves estimating the future cash flows that the startup will generate and discounting them back to their present value using a discount rate. This method is grounded in the principle that a dollar today is worth more than a dollar tomorrow due to its earning potential.

Process:

• Forecast Future Cash Flows: Project the startup's revenue and expenses over a certain period.

• Determine Discount Rate: Typically, the Weighted Average Cost of Capital (WACC) is used.

• Calculate Present Value: Discount the future cash flows back to their present value.

• Sum of Present Values: Add up all the discounted cash flows to get the start-up's valuation.

Pros and Cons:

+

• Provides a detailed and quantitative analysis.

• Considers the time value of money.

_

• Highly dependent on the accuracy of future cash flow projections.

• Complex and time-consuming.

Comparable Company Analysis (CCA)

CCA involves comparing the startup to similar publicly traded companies or recently acquired private companies. By analyzing the comparable attributes, investors can estimate the value of the start-up based on market multiples (e.g., price-to-earnings, EV/EBITDA).

Process:

• Select Comparable companies and attributes: Identify companies similar in size, industry, and growth stage.

• Calculate Multiples: Determine valuation multiples from the comparable companies and their attributes.

• Apply Multiples: Apply these multiples to the start-up’s metrics (e.g., revenue, EBITDA).

Pros and cons:

+

• Relatively simple and quick.

• Reflects current market conditions.

_

• May not always have perfect comparable attributes.

• Doesn’t account for unique aspects of the start-up.

Precedent Transaction Analysis

This method looks at the valuations of similar companies in past transactions. It helps investors understand what the market has been willing to pay for similar start-ups.

Process:

• Identify Precedent Transactions: Find similar companies that have been recently sold or funded.

• Analyze Transactions: Look at the valuation multiples from these transactions.

• Apply Multiples: Use these multiples to estimate the start-up’s value.

Pros and Cons:

+

• Provides real-world data points.

• Reflects historical market behavior.

_

• Past transactions may not reflect current market conditions.

• Data availability can be an issue.

Venture Capital (VC) Method

The VC method is a popular approach for early-stage start-ups. It estimates the potential exit value of the start-up and works backward to determine the current value, taking into account the desired return on investment.

Process:

• Estimate Exit Value: Project the potential future sale price of the startup.

• Determine ROI: Decide on the target return on investment.

• Calculate Post-Money Valuation: Divide the exit value by the ROI to get the post-money valuation.

• Calculate Pre-Money Valuation: Subtract the investment amount from the post-money valuation.

Pros and Cons:

+

• Simple and intuitive.

• Focuses on potential future value.

_

• Highly speculative and dependent on assumptions.

• Doesn’t consider current financial performance.

Scorecard Valuation Method

This method adjusts the average valuation of similar start-ups based on specific factors such as the strength of the management team, market size, product, and competition. It is often used for early-stage start-ups.

Process:

• Determine Average Valuation: Find the average valuation of similar start-ups.

• Assign Weights: Assign weights to different factors (e.g., team, market, product).

• Score Start-Up: Score the start-up on each factor relative to its peers.

• Adjust Valuation: Adjust the average valuation based on the start-up’s scores.

Pros and Cons:

+

• Comprehensive and considers multiple factors.

• Relatively easy to apply.

_

• Subjective scoring.

• Requires good knowledge of the start-up’s ecosystem.

Berkus Method

Developed by angel investor Dave Berkus, this method assigns a range of values to different risk factors (e.g., product development, technology, execution) to estimate a start-up’s worth. It is simple and often used for concept-stage start-ups.

Process:

• Assign Values: Allocate a value to different aspects of the start-up (e.g., idea, prototype, quality of team).

• Sum Values: Sum Values: Add up the values assigned to each aspect to get the total valuation.

Pros and Cons:

+

• Simple and easy to understand.

• Useful for very early-stage start-ups.

_

• Can be overly simplistic.

• Relies heavily on subjective judgments.

In this Part-II of the startup valuation we have seen a few basic valuation methods on how startup valuation is calculated. For further reference and study you can check the links provided at the bottom of this article. This blog aims at providing you with the basic knowledge and spike an interest for you to learn about these methods further. Knowing and learning about these methods will clarify a lot of your doubts and unveil the mystery around valuation. If you haven't read yet then please take a look at the ‘7Ps Framework of Fundraising’ to understand an easily implementable model for boosting up your fundraising initiative.

Learning is fun but learning in a structured approach is effective and powerful. And, that’s exactly what the purposes of this series of startup valuation and fundraising blogs are. In the Part-III of this series we would take a look at how startup valuation works that is how are these methods used in different stages of a startup. I’m also going to bring in a few interesting perspectives which might be of help to you as a new Founder. Stay tuned for the next update.

Happy fundraising!

PS: Links for further reference and study

Discounted Cash Flow (DCF) Method

Comparable Company Analysis (CCA)

Precedent Transaction Analysis

Venture Capital (VC) Method

Scorecard Valuation Method

Berkus Method

Additional Links:

Berkus Method vs Scorecard Method

Scorecard helps Angels value early

PS: The brand names, logos, websites, links etc. mentioned in this article belong to their respective owners and the author or his representatives claim no right or association with those brands in any manner. The views expressed are strictly personal and mean no disrespect or harm in any manner to any party or person or organization.

Disclaimer: The above article is based on personal understanding and views of the author. The concepts discussed are solely for informational purposes and should not be considered as professional advice or guidance. The author does not take responsibility for any positive or negative impact resulting from the application of these concepts or ideas. Readers are advised to exercise their own judgment and discretion when implementing any information provided in this article. The author recommends seeking professional advice or conducting further research to verify and validate any concepts or ideas discussed. The author shall not be held liable for any consequences or damages arising from the use of the information presented in this article.

Image courtesy: www.pixabay.com, www.freepik.com