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Five key approaches to startup valuations

Understanding business valuations: Part 4

 
 
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The most commonly used methods for valuing startups of various sizes and stages in the lifecycle.

Read time: 4 minutes

  • Asset-based valuations are simpler but limiting

  • Berkus Method suitable for pre-revenue businesses

  • First Chicago Method better for more mature startups

There are myriad ways to value a startup or other businesses, and often a combination of approaches will be used alongside market conditions, forecasts, competition, investor experience and proprietary systems.

The correct method for your business will depend on a multitude of factors, not least what stage in the startup lifecycle it is at. If it has yet to produce any revenues using a time-consuming and complex method that requires a lot of data is not suitable. If your business is further along the growth journey with more measurable assets and resources a more comprehensive approach is better suited. 

Here we look at five tried and tested approaches to valuation that suit different types of startups. We explain the models the methods outlining their advantages and limits.

Find the rest of the series here:
 

Asset-based valuation

A simple way to assess the value of a pre-revenue company is through the asset-based model. The asset-based approach to valuation focuses on a company's net asset value (NAV), or the fair market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business.

The downside for a fast-growth startup is that it does not reflect or forecast future performance. It does not, for instance, include in its evaluation the value of a company’s brand or intangibles that other methods account for. This is limiting as many startups by nature are based on intangibles, such as ideas, team skills and processes. 

The argument founders would make is that a company is worth more than the sum of its parts. Investors are betting on future potential and this method doesn’t show how their investment can generate returns.

The Berkus Method

Created in the 1990s and named after prominent US angel investor Dave Berkus, the Berkus Method has been adjusted and updated several times to reflect the market. At its core, however, the approach “assigns a number, a financial valuation, to each major element of risk faced by all young companies — after crediting the entrepreneur some basic value for the quality and potential of the idea itself”, according to Berkus.

It calculates the valuation based on five elements:

  • Sound Idea 

  • Prototype

  • Quality Management Team

  • Strategic Relationships

  • Product Rollout or Sales

The maximum each element can be assigned is $500,000, meaning your startup’s value could reach $2.5m.

The Berkus Method is a flexible and user-friendly valuation method for pre-revenue startups but is not appropriate value a company with recurring revenue streams.

Discounted Cashflow Method

The Discounted Cashflow Method seeks to forecast how much cash a business will have in the future. The value is calculated based on future cash flows, which should be discounted at a certain rate, which helps to obtain the present value.

The downside of this method is that it based on estimates, much like a forecast. Its success is based on the accuracy that its user can forecast future market conditions and make reliable assumptions.

The First Chicago Method

The First Chicago Method is also known as the Venture Capital Method. It works best for startups that have made revenue and is the most complicated and time consuming of these approaches. Therefore it is better suited to Series A and beyond. It is typically used by private equity and venture capital firms.

The First Chicago Method requires you to create three possible different future scenarios:

  • Best Case

  • Average

  • Worst Case

To do this you will need data such as earnings, cash flows, exit-horizon, revenue, financial forecasts, for each scenario. These scenarios are then combined into one weighted average valuation for your company. 

Comparable Transactions

This approach employs uses data from comparable transaction to estimate the value of a startup. The aim is to find a company in the same industry with a similar business model to use as an accurate valuation benchmark.

The key steps for this method are:

  • Identify the relevant comparable transactions
  • Calculate the key valuation metrics for those transactions

In broad terms, for example, if an app similar to the one developed by your startup was recently valued at £3m and it had 100,000 users, this means each user is valued at £30. This comparable transaction benchmark can be used by investors to value your offering.



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