Startup valuation: Meaning, methods, and more

What is startup valuation?

A startup valuation is the various process of identifying the overall estimated worth of a startup. Investors adopt certain factors to establish this valuation, these factors include the startup’s progress to date, the likelihood of success in the business idea, and others.

When valuing an already existing company, all that needs to be done is to turn to the already existing company’s audited balance sheet for clarity. The balance sheet contains all the revenue made by the company, including the profits, loss, the company’s assets, liabilities, and others. Experts could come to a rounded figure or a gross estimate of the valuation of the already existing company, following its financial statements generally. 

Nonetheless, there lies a difficulty when accessing the valuation of startup companies, this is because as a startup, it probably hasn’t started business and definitely would not have a balance sheet, financial statement, or any accounting records. The only thing the startup brings to the table is the next big idea, a dedicated team, and a strong passion, which the investors are willing to take a risk at.

This article provides all there is to know on valuing a startup company for funding.

Why is it necessary to value a startup company?

Valuing startups has become more than necessary in today’s business world. To understand why a startup is to be valued, we would need to understand why valuing an already existing company is necessary for the first instance. 

A company is valued by investors to know if the investment given to the business is worth the figure and if the company isn’t in a bubble. For instance, ADX Ltd requires a loan of $4 billion from the People’s Bank, the loan is payable at an interest of 10%, which equals $4.4 billion to be paid. The balance sheet of ADX Ltd showed that the company’s total revenue has never exceeded $200 million, its total assets are less than $300 million, and its liability is $2 billion. The likelihood of ADX Ltd paying up the debt of $4.4 billion is very unlikely. 

The same valuation done for ADX Ltd is the reason for valuing startups, but not just as easy as it was to value ADX Ltd. When investors seek to invest in startups whether it’s through seed, pre-seed or series funding, the investor would want an actual value of the company to be sure that the money invested is sufficient and the stake offered is fair. If investor A intends to invest $50,000 in SJX Ltd (a startup) valued at $500,000; this invariably means the fair market stake of SJX Ltd would be 10% for $50,000; anything short of this might be discouraging to investor A. 

Startup valuation methods

1. Market multiple approach

Best for venture capitalist firms

The market multiple approach is the best approach adopted by investors when seeking to fund startups. The approach takes the form of the startup being valued by the already existing valuations of similar businesses. For instance, if the company is an e-commerce startup, the investors would look to the valuation of other e-commerce startups when in similar stages to the startup. 

A shortfall to this system is that the actual market value of previous other similar startups might be difficult to acquire; a majority of startup transactions are held privately with confidentiality and non-disclosure clauses being the norm of the day.

2. Cost-to-duplicate approach (CTD)

Best for being ease and simplicity

The CTD is one of the oldest forms of valuing startup companies across the world; it is also arguably the simplest form. When using the CTD method all the startup is required to show is the cost expended by the founders for establishing the startup. 

The CTD is mostly concerned with the actual cost expended and not the intangible costs like brand name and intellectual property. For instance, a fintech startup would be valued by the actual cost expended to set up the app, the cost used to acquire varying licenses and everyday costs from office rent to the cost of furniture. 

3. Discounted cash flow (DCF) method

Best for series funding

The DCF method looks to the future of the startup ad values it based on the gains expected. It is the opposite of the cost-to-duplicate method. For the DCF to be applicable, the startup must possess a feasible and clear business plan that is acceptable to the investor DCF system to be applied. This system is also the most applied in today’s funding rounds, especially at the series level. 

A shortfall in this method is that it is dependent on having excellent forecast personnel, a slight mistake can be fatal to the overall aim of the funding in the end.

4. Development stage approach

Best for pre-seed and seed funding

This is arguably the best method adopted by venture capitalist firms for pre-seed and seed funding companies. This method sets thresholds for startups to meet, if the startup meets such threshold its value climbs and the risks falls. 

The thresholds are dependent on an agreed formula by the investors with the startup and can in turn influence investment decisions for angel firms and venture capitalists. One advantage of the development stage approach is that it offers the venture capitalist firm the opportunity to break the startup into small bits and measure its success using such division, the investors get a clear picture of the dedication borne by the founders to the company.

For example, if JDS Ltd (an e-commerce startup) seeking $50,000 for its pre-seed funding stage, the threshold can be thus:

Stage of the startup developmentEstimated value (USD$)
Registered under the Corporate Affairs Commission50,000
Registered in the United States 250,000
Built a functioning website400,000
Built a functioning mobile App500,000
On-boarded over 100 users1 million
Possesses experts and professionals in the team1,500,000
On-boarded over 5 stores on the e-commerce platform2 million
Created a pitch deck, business plan and five years financial forecast3 million
Has partnership or investments from other well known venture capitalists4 million
Possesses possible revenue growth prospects5 million and above

Conclusion

Valuing a startup can be a heck of a deal with a series of professionals grappling with varying methods to come up with an actual value that meets the expected circumstances in the future. The article above offered insight into the possible techniques to adopt when seeking to value startups.

Frequently Asked Questions (FAQs)

Is investing in a series C startup considered high risk?

Not really, at a series C, a startup has already reached its growth stage with a functioning balance sheet and accounting record that can be relied upon.

How many years should be sufficient enough to review a company’s balance sheet?

Five years’ balance sheet is sufficient to get a company’s true financial position.

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Richard Okoroafor

Richard Okoroafor

Richard is a brilliant legal content writer who doubles as a finance lawyer. He brings his wealth of legal knowledge in corporate commercial transactions to bear, offering the best value that exceeds expectations.

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