Series: How do angel investors value startups? (1 of 9)

When founders begin their funding adventure the task of determining valuation for their startup is both incredibly important and complex. Given that these companies often lack historical financial performance and face uncertain futures, founders and their angel investors must agree on how much the concept or company is worth. The good news is that there are several common approaches to determining valuation and at least one can usually be adapted to suit the unique circumstances of any startup or early-stage venture. Here’s a comprehensive look at various methodologies used by angel investors:

1. Discounted Cash Flow (DCF) Analysis

DCF involves projecting the future cash flows of the startup and discounting them back to their present value using a discount rate that reflects the risk. This method is challenging for startups due to the difficulty in accurately forecasting cash flows.

Steps:

• Project future cash flows.
• Determine a discount rate, often using the weighted average cost of capital (WACC).
• Discount the future cash flows to present value.
• Sum the present values to get the total valuation.

Pros:

• Theoretically sound and focuses on cash generation potential.

Cons:

• Difficult to apply to startups due to uncertain and volatile cash flows.

2. Comparable Company Analysis (CCA)

CCA involves comparing the startup to publicly traded companies or recently acquired companies in the same industry. Key financial metrics such as price-to-earnings (P/E) ratio, enterprise value-to-revenue (EV/Revenue), or EV/EBITDA are used.

Steps:

• Identify comparable companies.
• Collect valuation multiples from these companies.
• Apply these multiples to the startup’s metrics.

Pros:

• Relatively straightforward and uses real market data.

Cons:

• Finding truly comparable companies can be challenging.

3. Precedent Transactions Analysis

This method looks at recent transactions of similar companies to establish a valuation benchmark. It involves analyzing the acquisition prices of comparable companies.

Steps:

• Identify recent transactions involving similar companies.
• Analyze the multiples paid in these transactions.
• Apply these multiples to the startup’s financial metrics.

Pros:

• Reflects current market conditions.

Cons:

• Difficult to find truly comparable transactions, especially in niche markets.

4. Venture Capital (VC) Method

This method estimates the startup’s valuation based on the expected return on investment (ROI) for venture capitalists. It involves estimating the future exit value and discounting it back to present value.

Steps:

• Estimate the startup’s exit value (e.g., via IPO or acquisition).
• Determine the expected ROI.
• Calculate the present value of the exit value using the ROI as the discount rate.

Pros:

• Simple and aligned with VC’s investment horizon.

Cons:

• Highly dependent on the assumed exit value and ROI.

5. Scorecard Valuation Method

This method adjusts the average pre-money valuation of comparable startups by scoring the subject startup against key factors such as the strength of the team, market opportunity, product stage, and competitive environment.

Steps:

• Determine the average pre-money valuation of similar startups.
• Score the startup against several key factors.
• Adjust the average valuation based on the scores.

Pros:

• Comprehensive and factors in qualitative aspects.

Cons:

• Subjective and relies heavily on the assessor’s judgment.

6. Risk Factor Summation Method

Similar to the scorecard method, this approach adjusts a base valuation by adding or subtracting value based on various risk factors, such as management, stage of business, market size, technology, and competition.

Steps:

• Establish a base valuation.
• Identify and assess risk factors.
• Adjust the base valuation based on the risk assessments.

Pros:

• Accounts for both quantitative and qualitative factors.

Cons:

• Can be subjective and complex.

7. Cost-to-Duplicate Method

This approach estimates the cost to build a similar startup from scratch. It involves summing up all the investments made to date, such as technology development, hiring, and operational costs.

Steps:

• Calculate the total cost incurred in developing the startup.
• Estimate the cost to replicate these efforts.

Pros:

• Simple and tangible.

Cons:

• Ignores market potential and future growth prospects.

8. Berkus Method

Named after venture capitalist Dave Berkus, this method assigns a value to different elements of the startup, such as the idea, prototype, quality of the management team, strategic relationships, and product rollout or sales.

Steps:

• Assign a dollar value to each element of the startup (e.g., idea, prototype, management team).
• Sum these values to get the total valuation.

Pros:

• Provides a structured approach for early-stage startups.

Cons:

• May undervalue the potential of disruptive startups.

Conclusion:

Choosing the right valuation methodology depends on the stage of the startup, the availability of comparable data, and the specific circumstances of the business. Often, a combination of methods provides the most accurate picture. It’s also essential to remain flexible and revisit valuations as the startup progresses and more data becomes available.

“Series: How do angel investors value startups?” is pulled in part from the Founders Guide to Building an Empire seminars, Copyright 2024 SC Capital Partners.