A Manifesto for Startup Valuation

1. What is A Startup?

A startup is a company specifically designed to achieve rapid growth (Dealroom, 2024). These innovative ventures are typically backed by venture capital investors, aka angels if individuals, who see high potential for returns.

In their earliest stages, startups usually operate● without revenue (pre-revenue stage), ● without users (pre-user stage), or ● even without having a working product (idea stage).

This early-stage phase is particularly challenging as startups focus on product development, market validation, and on building their initial user base in order to prove their business model and establish product-market fit. Strictly speaking, startups that generate less than $50,000 in monthly recurring revenue (MRR) are the early-stage ones still validating their business model and working toward scaling and sustainable growth.

When startups succeed with their growth strategies, they evolve through the next stages: first into scaleups with more than $50,000 MRR, then into growthups exceeding $1,000,000 MRR, and ultimately emerging as established corporations. Some startups reach extraordinary valuations exceeding $1 billion, earning the "unicorn" status in the startup ecosystem, or even $10 billion valuation earning the “decacorn” status.

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2. What is Startup Valuation?

Startup valuation is the process of determining the economic worth of a young company. Valuing a startup is very important. It needs a special method, especially for new startups.

A Simple Explanation for a Broad Audience

At its core, startup value is figuring out how much money a company in its early stages could make in the future. You can't tell how big the tree will get from the seed. The process looks at things like the size of the market, the strength of the team, how special the product is, and how the company can grow. Early investors in Airbnb, for instance, apparently thought about more than just the small gains the business made at first. Always think about the future when you're judging a company.

Why Startup Valuation Different from Valuing an Existing Businesses

There are several reasons why valuing a startup is very different from valuing an existing business.● Companies that are new don't always make money, so normal ways of valuing them that are based on past success don't work for them. This is why investors and founders need to put their money where they think it will do the most good.● Growth potential: a startup's real value is not in how it is now, but in what it could become in the future.● Uncertainty and risk: since startups operate in uncharted territories, this makes their future success harder to predict. This is why venture capitalists often invest in several startups, understanding that many of them may fail, but one big success can offset several losses.● Intangible assets, such as a startup's intellectual property like copyrights and the collective expertise of the team, become a significant portion of a startup’s worth.● Startups tend to stick to their strategies, better say rigid, which makes it less adaptive and less confident in how they will do in the future.

Related Articles

● The Hypothesis Testing Method for Startup Valuation and Management● The Method of Real Options to Evaluate Innovative Startups ● Real Options Approach to Evaluate Strategic Flexibility of Startups● Financial Tools for Managing Startup Projects● Real Options for Assessing Financing Strategy and Startup Valuation● Valuation of a Source of Startup Funding Using Real Options Approach

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3. Why is Startup Valuation Important?

For Founders

● Raising investments: Reasonable valuation helps you attract venture capitalists faster as it provides a basis for negotiating how much equity to give up in exchange for money.● Team motivation: On early-stages, equity is a great way to get and keep good talent. When early employees understand the potential value of their equity stakes, it can drive them to work harder for the startup’s success. This is very important when you are short on cash and can't pay high prices.● Fair pricing: A good price keeps founders from giving away too much of their business too soon. If a founder undervalues their business and gives away 50% for a small investment, for example, they might not be able to get more investments in future or might even lose control of their business.

For Investors

● Valuation helps investors decide if the possible return is worth the risk when they are making investment choices. Venture capitalists, for example, want at least a 10-fold return on their investments to make up for the high risk of investing in startups.● Getting a correct valuation lowers the risk of paying too much for a piece of the company. This is very important because paying too much can cut returns by a lot, even if the company succeeds.● Venture capitalists and angel investors need to know how much startups are worth in order to handle their investment portfolios well. They need to mix investments with a lot of risk and profit with ones that are safer.

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4. Primary Startup Valuation Methods

There is a number of traditional and modern company valuation methods that can be used to determine valuation of a startup, each with its strengths and limitations. Being crucial tools for both founders and investors, these startup valuation methods, however, can't compare with the Hypothesis Testing Method suggested here.

DCF Method: for startups with predictable revenue

Discounted Cash Flow (DCF) Method is the most common traditional business valuation approach that is based on projecting future cash flows and discounting them back to present value. It uses a conventional linear concept of Time Value of Money converted into a discount rate as a demeanor of risks related to the uncertain future. It's particularly useful for scaleups and growthups with more predictable revenue streams so that their risks are based on the general factors accounted into a discount rate.

Formula: DCF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + ... + CFn / (1+r)^n , where: CF = Cash Flow, r = Discount Rate, n = Number of Years.

In this case, a startup might be worth $15–20 million if it expects its free cash flow to be $1 million in the first year and to grow at 20% per year for 5 years, with a discount rate of 15% and a terminal multiple of 10x.

DCF Method is a basement for many other derivative approaches such as Income-based Valuation that is based on the income the business is expected to generate over time. It's similar to the DCF method but may use different techniques to project future income.

Berkus Method: For early-stage startups

The Berkus Method, developed by angel investor Dave Berkus, is widely used for evaluating early stage startups as it is very simple and straightforward approach. Instead of requiring bulky financial modelling, it assigns a monetary value to five startup’s success factors:

1. Sound idea (basic value): Up to $1 million2. Prototype (reduces technology risk): Add up to $1 million3. Quality management team (reduces execution risk): Add up to $1 million4. Strategic relationships (reduces market risk): Add up to $1 million5. Product rollout or sales (reduces production risk): Add up to $1 million

Under this method, a company with a good idea, a working prototype, and a strong team but no sales yet might be worth $3 million.

VC Method: For early-stage startups with high growth potential

Venture Capital (VC) Method is popular among venture capitalists evaluating startups with high growth potential. It keeps a narrow focus on the expected return at exit applying an IRR (Internal Rate of Return) or a minimum required/expected return logic to a required investments and vice versa.

Formula: Post-money Valuation = (Exit Value) / (Expected ROI), Pre-money valuation = Post-money Valuation - Investment Amount.

As an example, if a venture capitalist thinks that a company will be worth $100 million when it goes public in 5 years and wants a 10x return on their $5 million investment, then the post-money valuation is $100M / 10 = $10M and the pre-money valuation is $10M - $5M = $5M.

Risk Factor Summation Method: For early-stage startups

This method is another good way to value early-stage startups. Instead of just using financial metrics, it measures a number of qualitative risk factors that could affect the success of the company. The process begins with a base value, typically derived from Berkus or VC Methods. The process begins with a base value, typically derived from Berkus or VC Methods.

Common risk categories may include: management risk, stage of business, legislation/political risk, manufacturing risk, sales and marketing risk, funding/capital raising risk, competition risk, technology risk, litigation risk, international risk, reputation risk, potential lucrative exit.

A standard scale, usually running from -2 to +2, is used to rate each risk factor. Lower scores mean more risk, while higher scores mean opportunities or factors that lower risk. The base value is then changed based on the total effect of these ratings. This gives a more complete valuation that looks at both the quantitative and qualitative parts of the business.

Multiple Method: For startups with predictable revenue

In this method, aka company comparison and peer analysis, the startup's financial success is predicted up to a certain point in the future (usually the exit), and a valuation multiple based on similar companies is used, such as price to earnings, price to EBITDA, price to sales, and so on.

When applying the Multiple Approach, follow these simple steps:● Forecast future revenues, expenses, and earnings.● Apply an appropriate multiple based on industry standards such as price to earnings, price to EBITDA, price to sales, and so on.● Discount the future value back to present using DCF Method explained above.

Multiple Approach can be particularly useful for startups with predictable revenue and in industries with established valuation multiples.

Cost-to-Duplicate Method: For startups with tangible assets

Based on how much it would cost to build the same startup from scratch, this can include rebuilding real assets, creating intellectual property, putting together a team, getting a foothold in the market, and so on. For startups with valuable physical assets or unique technology, the Cost-to-Duplicate Method is especially helpful because it gives a clear starting point value based on measurable development costs and infrastructure investments.

This method works best when: ● Substantial IP/patents exist, making reproduction costs quantifiable● Physical assets or specialized equipment form a major part of operations● Complex technical development would require significant time/resources to replicate● Market entry barriers are tied to specific infrastructure or capabilities

For example, a biotech startup with custom lab equipment and patented processes can be valued more accurately this way than using purely market-based methods. However, this method may undervalue companies where the main assets are intangible (like brand value or network effects). Cost-to-Duplicate Method is an asset-based type of valuation that is a fundamental approach to determining a startup's worth by assessing the total value of its possessions and resources.

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5. What Does Effect Startup Valuation?

Size of the market and growth potential

When you evaluate market potential, you need to pay close attention to three factors. First, the total addressable market (TAM), which is the total amount of money the company could make if it could reach all of its target customers. Second, the market's growth trajectory, since markets that are growing quickly give new startups more room to grow, And third, the realistic market share the startup could get given its competitive advantages and ability to carry out its plans. These three things set a limit on what the company could be worth.

Team knowledge and experience

The people behind a startup can make it worth much more to investors. When founders have already built and sold successful companies, investors see less risk and often value the company higher. When you have someone in your team who really knows the industry inside and out is crucial. For founders, it means they are less likely to fail. On top, a big name on board as an advisor or executive team member can open you some doors and add credibility.

Product or service differentiation

A startup's value jumps significantly when it has something truly special that sets it apart from the crowd. Investors look for solutions that don't just match what's already out there, but solve problems in a clearly better way - like how Uber made getting a ride dramatically easier than hailing a taxi. But having a great idea isn't enough; the startup needs something that makes it hard for others to copy their success, whether that's special technology they've developed, a patent that protects their invention, or the kind of network effect that makes Facebook valuable because everyone's already using it.

Technology and intellectual property

The long-term value of a startup is built on its technology and intellectual property. When you get patents and trademarks, they protect your new ideas and give investors confidence in the marketability. Unique technology that is hard to copy adds massive value, and research and development competencies that have been proven to work add extra confidence in your creativity.

Traction and customer acquisition

How quickly and easily you can attract, acquire, engage, and keep customers has a big impact on your valuation. Fast user growth demonstrates a product-market-fit (market acceptance) and further scaling potential. Even in pre-revenue stages, strong customer engagement and retention must serve as a proof of product-market-fit. When you put it together with consistent revenue growth dynamics, these can tell you an appealing story of long-term business growth.

Investor sentiment and market conditions

The overall economic situation and market trends play a significant role in shaping startup valuation beyond business metrics. Apparently, a growing economic environment drives higher valuation as investors get more appetite for risk, while specific industry momentum, not to mention hypes, open good funding opportunities. Valuation of competitors, for example through recent exits or funding rounds, establish valuation benchmarks.

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