Year after year, startups in the United States fundraise billions of dollars at increasingly higher and higher valuation levels. VCs and other institutional investors continue to fundraise higher and higher amounts to invest into early to late stage startups.
With so much capital in circulation, startups are incredibly eager to secure some of that for themselves. But before they can receive investment, startups have to determine what the value of their startup is. This will help in calculating how much equity they would have to give up to receive the investment amount they ask for.
Figuring out how to properly valuate your startup will help you better prepare for your fundraising efforts and confidently approach investors. This is something that every budding startup founder should be able to do, or at the very least be willing to learn to do.
So how does a founder go about valuating their startup? What even is a startup valuation? This article will go over the methods that a founder can use to valuate their startup and give insights on what those methods mean to investors. We will also discuss how they contribute to a holistic makeup of a startup.
To start, a startup’s valuation is very simply the value of a startup. How much it is considered to be worth. So from the jump, it would seem that determining a startup’s valuation can be a subjective process. However, there are quite a few quantitative processes that a founder can follow to get an unbiased assessment of their startup’s valuation.
Before jumping into the thick of it, a quick and also very sensible way of ballparking your startup’s valuation is by looking at your market and finding a (set of) comparable company/ies. Obviously, every founder would like to think their company differentiates itself from its competition but the purpose of ballparking the valuation is to help you create a benchmark to measure your quantitative estimate against down the road. In addition, investors will often measure against comparable companies anyways in their valuation process.
Investors will often use “instinctual” methods to estimate the value of an early-stage startup, according to Seedcamp, where they will “size the ‘likely’ maximum value” of a startup. The main one being looking at transaction comparables, meaning what the market was willing to pay for similar startups in the past.
After doing the market ballpark to gauge your startup’s valuation, you can use any of the following methods to more quantitatively calculate.
Quantitative methods are very reliable and standardized ways of calculating the valuation of a startup. Here are some of the most conventional quantitative methods founders and investors use.
Discounted Cash Flow Method
Financial service and technology company Brex encourages founders to calculate the discounted Cash Flow method by taking your company’s future cash flow forecasts and then applying a discount rate, or the expected rate of return on investment (ROI).
One insight is that a higher discount rate is seen by investors as suggesting a riskier investment. For investors, they will need to see a stronger growth rate to feel confident about a higher discount rate in a startup.
Related to the Discount Cash Flow method is the First Chicago method, which essentially uses the DCF method in the context of three situations. One in which the startup is in a best-case scenario, one that could be considered a mid-case scenario, and finally a worst-case scenario for the startup. The First Chicago method is great because it lets you consider these scenarios and make a nuanced estimation of value for a company.
Book Value Method
The Book Value method is a pretty simple asset-based valuation method. A company’s book value can be calculated by taking the total value of its assets and subtracting that amount from its liabilities. This is essentially equating your startup’s valuation to its net worth. This is a pretty conventional method of valuation and you should definitely have this figure on hand if an investor asks you for it.
This method is pretty much summed up by its name. All that you need to do for this method is calculate how much it would cost someone else to recreate your startup. You would just have to add up the fair market value of your physical capital and any costs incurred in your startup’s developments. This can be whatever was spent on research, payroll, patent, licensing, and so on. A problem with this method is that it most likely will not encapsulate the true value of your startup, but it is great for ballparking.
Thinking about quantitive analysis holistically
These methods can be very useful when considering your startup’s value but individual methods often will not capture the full scope. Here are some important considerations that TechCrunch emphasizes as important when thinking more holistically about the value of your startup.
This is definitely one of the first aspects of your company metrics that any investor will take a look at when evaluating your startup. Institutional investors will more readily cut a check for companies with positive cash flow statements and diligent balance sheets. Here are some of the most important metrics.
Monthly Revenue Growth
To calculate your company’s MRG, just add up this month’s revenue, subtract by the previous month’s, and divide by that previous month’s revenue. Different startups will have different benchmarks when it comes to MRG and so it’s important to frame your MRG in its appropriate context.
Revenue Run Rate
To find the revenue run rate, take the sum of the revenue of the previous month and multiply that by twelve. If it is early in the year, your startup’s performance so far can help to project what your revenue will look like later in the year. You might even be able to compare the revenue run rate projection with how revenue performed the previous year.
There are two kinds of margins to consider, gross margins and net margin. Gross margin is defined as total revenue minus how much it cost to produce the goods that were sold, divided by total revenue.
Net margin is different from gross margins because you would minus total revenue by total expenses before dividing by total revenue. Margins are important for assessing how a startup is able to spend capital that is invested into it.
Burn Rate and Runway
Burn rate is a fundamental metric that every founder should monitor. Burn rate is the calculated monthly operating loss per month. For startups that aren’t generating revenue, you’re operating on a burn rate. How much is your startup losing every month to exist? How long can your startup sustain this? This can be answered by figuring out your Runway. This calculation involves dividing the total amount of capital(money to work with) that a startup has and dividing it by the monthly burn rate. This will give you the number of months that your startup has to go before you run out of money.
After financial metrics, investors will want to evaluate market metrics related to your startup. When looking at a startup, market metrics will tell them if a startup is even worth investing in.
Is there a sizable market and what is the activity in the market look like are two very important questions that market metrics can answer?
If it’s a small market, then even if a startup is able to capture it won’t be as financially meaningful for an investor to spend their time and money. Here are some of the metrics that are worth considering.
Total Addressable Market
This is the total amount of money or value that a startup specifies as its target space. TAM is important for forecasting the value of a fully scaled startup and is an easy distinguishing metric for investors who look to invest in specific market sizes.
This is an aspect of your business that is all-important. This is where one can see the life and viability of your startup’s ambitions. Some metrics that are helpful for illuminating these things are the Magic Number, Basket Size and Order Velocity
So you want to have a company that has actual, flesh-and-blood customers? If so, then you are going to have to build sales channels to efficiently build revenue. These metrics are helpful ways to judge the success of those efforts.
The magic number helps us find the return on investment that a startup will have for every dollar they spend on sales and marketing.
You calculate the magic number by taking the net growth of subscription revenue over two quarters, multiplying it by 4, and finally dividing it by the total amount spent on sales and marketing. For every dollar spent, the magic number is what you get back in additional revenue.
A magic number above one is a good indicator of a startup’s ability to grow in a scalable fashion with respect to sales and marketing. A magic number below one suggests that the company has inefficiencies in that same regard.
Basket Size and Order Velocity
Basket size takes a look at the average sales price that a customer would pay for a typical order in your business. Next, order velocity is how long it takes the customer to make that purchase again. Basket size and order velocity is great for evaluating the business model of a startup(customer makeup, purchasing habits, etc) and forecasting what that model would look like at scale. These are important
Customers are what keep a company alive(besides raw capital), and so VCs will of course take user metrics into great consideration when valuating a startup, as should founders. One super important user-related metric is the K-value. This metric is more easily assessed for technology startups.
To find K-value, choose a base time frame. Then take the number of users at the beginning of that time frame. Then, track the number of invites that those users send out to people and add up to the total amount of new users that join from those invites.
Finally, divide that number of new users by the number of users you allocated at the beginning of the base time frame and add 1. So if within a month, you had 100 users and at the end, you had 10 new users, the ratio would be .1, and adding 1 to it gives us a k-value of 1.1.
The significance of the k-value is that it measures virality and that it is exponential. The K-value became an important metric with the advent of social media startups and is probably the most important metric for them, besides retention of course.
Depending on the startup, a single metric can be singularly important in projecting the value of the startup and thus its valuation. This is why they are so important when thinking about metrics, which are often quantitative assessments when considering your startup’s valuation from a holistic standpoint.
Wrapping it up
It is incredibly important that you are able to think about your startup’s value in a quantitative and holistic fashion. Following these methods can give you great insights into your business model and the direction of your startup in ways you might not have considered.
By comparing against similar companies in your market, you can see what kind of rounds they were able to raise and their exit paths if applicable. After that, using specific quantitative methods will help you get a bunch of figures for the strength and future of your startup. This is super valuable data for creating a strategy for the long-term path of your startup.
As a founder, it is important to get a calculation of your startup’s valuation even before you start trying to meet investors. Without having done some of these methods, your understanding of your own company will be shallow compared to what you will know after doing them. You will be better prepared to answer any questions that investors will have, and you might even notice glaring problems in your business model that you didn’t know of before.