The value of a startup is related to various factors including the project that has determined the creation of a young company, its potential on a commercial level, the skills of the team that make it up, the idea’s innovative scope from which it originated, and the technologies used. But how to evaluate a startup project? For this purpose, there are some approaches which, if applied correctly, allow to obtain accurate estimates. Each method has advantages and limitations that must be taken into consideration before choosing. Let’s find out what these are.
Why it is important to evaluate a Startup
“If you have an idea, you are a startup“. Starting from this slogan, read at the entrance of a business incubator in Krakow some time ago, it is useful to remember that at the base of every startup there is an intuition that leads to the creation of a new business. To support a good idea, however, financing is required, and public or private investors (such as business angels or venture capitalists) provide the capital. The primary purpose of a startup valuation is to understand the value of a project to convince the lenders to support it economically. As anticipated, the methods to achieve this goal are different. Below we will analyse some of the most qualified and effective methods.
Pre-money and post-money valuation
Pre-money valuation refers to the estimated value of a startup before any round of financing is disbursed, on the contrary, post-money valuation refers to its value after the acquisition of capital. Now, if a lender were to contribute to a startup project with € 100,000 and its pre-money valuation was € 1,000,000, the investor’s share would be 10%. On the other hand, if this valuation were equal to half a million, it would have a higher share equal to 20 percentage points. In the case of the post-money method, it is assumed instead that an investor estimates the value of a startup at € 1,000,000 and decides to finance it for € 100,000. If this valuation were to be confirmed, the overall value would rise to € 1,100,000 thousand, and the value of the shareholding held by the lender would have to be modified considering the difference. With pre-money valuation it is therefore possible to make a relatively accurate calculation of the current value of a project, while post-money valuation is the result of the sum between pre-money valuation and financing received. These methods allow entrepreneurs to understand what share of their business they are willing to sell, while allowing lenders to understand how much they can bet on it, in sight of an eventual capital gain on the investment. Sometimes, however, these approaches are strongly conditioned by information that is difficult to verify. For example: How much can financial projections set out in a business plan be reliable? To answer questions of this kind, alternative methods have been theorized that are able to take into consideration various factors useful for valuation.
The Berkus method
The Berkus method, by the very US business angel of the same name, starts from the consideration that, especially during the first stage, most startups’ incomes do not correspond to those expected, and can even be much lower. To avoid the danger of overestimating the value of a project, this method proposes a checklist based on five risk factors:
- Basic value: that is the risk embedded in the idea that you intend to pursue;
- Technology: the risk associated with the reference technology;
- Execution: the risk associated with the managerial qualities of a team;
- Market risks;
- Production and Consequent Sales: financial risk.
Each factor conventionally contributes a value between 0 and 500,000 dollars to the valuation of a startup, this means that the maximum predictable value for a pre-money valuation, based on the Berkus method, is equal to 2,500,000 dollars. The reference market and the valuation skills of the parties involved in the estimate determine the value of each factor, however, since these are partly subjective elements, the level of accuracy of the valuation can be exposed to arbitrary variables, such as the experience gained by investors.
The Scorecard method
The Scorecard method, also known as “Payne” from the surname of the business angel who theorized it, is essentially a benchmark based on the comparison of a startup with other similar entrepreneurial initiatives. In this case, the factors taken into consideration are seven, but they are able to provide a different contribution to the valuation:
- strength of the team or management (up to 30% of the final result);
- size of the reference market (up to 25%);
- product or service and technology used (up to 15%);
- commercial partnerships, marketing and sales channels (up to 10%);
- competitive context (up to 10%);
- need for further investments (up to 5%);
- other variables to consider for the type of project (up to 5%).
The percentages indicated are not binding, and can be varied according to the characteristics of the startup being evaluated. Since their function is to return a multiplier, in any case, we start from an average valuation of the sector in which the company will operate, and then modify the value of each factor based on the comparison with the other startups. For example, if the factors relating to “product and technology” of a startup were considered 10% higher than the average, the percentage value indicated should be equal to 110%. This would result in two multipliable values, 10% and 110%, the result of which is a weighting called Adjusted Weighting. Each factor allows one to obtain a specific Adjusted Weighting to be summed to the others, in order to get a final estimate calculated on the basis of the multiplier. The Scorecard method simplifies the creation of appraisals aimed at determining a value, but it has its limitation in the fact that it starts from predetermined valuations (averages) that only partially consider the specificity of a startup.
The Venture Capital Method
The method in question takes into account two factors in particular:
- the expected ROI (Return On Investment);
- the Exit Value, that is the terminal value of a startup.
It takes its name from the fact that it is used quite often by venture capitalists who are considering financing a young business during its early stages. Basically, it is useful to an investor who, by acquiring shares in a startup, expects a profit at the time of the exit from investment. In this case, the value of the post-money valuation is obtained by dividing the Exit value by the expected ROI, while for the calculation of the first one, a 5 or 8-year estimate of the terminal value of a startup is made by taking into account, for example, the expected profits. The Venture Capital method’s pre-money valuation is therefore the result of the subtraction of the investment from the previously obtained post-money valuation. We are therefore talking about an extremely selective method that could exclude from financing all startups that do not offer sufficient guarantees in terms of capital increases in the short term.
The Cost-to-Duplicate Method
In the Cost-to-Duplicate method, the entries for costs and expenses related to the launching of a startup and the implementation of its project play a fundamental role. Therefore, all possible outflows for tangible or intangible assets that could weigh on the financial statements of an entrepreneurial activity are included in the calculation. This method answers a simple question: how much could the duplication of a startup cost? If recreating an identical one requires a higher economic commitment, the investment in terms of capital could be justified, otherwise no watchful lender would pay more to create something that could be easily replicated from scratch. It is clear that the Cost-to-Duplicate method is particularly suitable for anyone who wants to avoid too risky investments and, from this point of view, the background of a team (for example the projects developed previously), the technologies used and the commercial aspects related to an entrepreneurial idea, have a decisive role in the valuation. On the other hand, however, an approach of this kind could penalize all those startups that develop particularly innovative ideas and, given the features of their projects, they would reap the fruit of their labor only in the long term. In the same way, factors that are hardly measurable, such as skills, networking capacity, patented solutions and business processes used could play a marginal role in valuations based on the Cost-to-Duplicate method.
Valuing a startup project is not easy, and investing in an innovative company comes with risks. For this reason, methods by which to obtain estimates as accurate as possible were defined. In any case, in order to formulate reliable valuations, it is necessary to know the startup ecosystem in detail, and become part of it. For this reason, Talent Garden has developed over the years an international community of innovators thanks to training courses dedicated to Digital Education, workspaces and networking opportunities within its study and coworking campuses. Talent Garden’s edutech network today includes 12 countries and focuses on issues related to data, marketing, design, coding, digital HR and business, all sectors with high added value that directly engage young innovative companies.