Business valuation is never straightforward – for any company. Valuing startups with little or no revenue or profits and less-than-certain futures is particularly tricky. Mature publicly listed businesses with steady revenues and earnings are usually valued using a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA), or based on other industry-specific multiples. But valuing startups that are not publicly-listed and may be years away from sales is much harder.

If you are trying to raise capital for your start-up or are thinking of putting your money into one, it’s important to determine the company’s worth.

Thinking About Cost-to-Duplicate

As the name implies, this approach involves calculating how much it would cost to build another company just like it from scratch. The idea is that a smart investor wouldn’t pay more for a company than it would cost to duplicate it. This approach will often look at the physical assets to determine their fair market value.

The cost-to-duplicate a software business, for instance, might be figured as the total cost of programming time that is gone into designing its software. For a high-technology start-up, it could be the costs to date of its research and development, patent protection, and prototype development. The cost-to-duplicate approach is often seen as a starting point for valuing startups, since it is fairly objective. After all, it is based on verifiable, historic expense records.

The big problem with this approach – and company founders will certainly agree here – is that it doesn’t reflect the company’s future potential for generating sales, profits and return on investment. What’s more, the cost-to-duplicate approach doesn’t capture intangible assets, like brand value, that the venture might possess even at an early stage of development. Because it generally underestimates the venture’s worth, it’s often used as a “lowball” estimate of a company’s value. The company’s physical infrastructure and equipment may only be a small component of the actual net worth when relationships and intellectual capital form the basis of the firm.

How Startup Ventures Are Valued

Valuing by Market Multiple

Venture capital investors like the Market Multiple approach, as it gives them a pretty good indication of what the market is willing to pay for a company. Basically, the market multiple approach values the company against recent acquisitions of similar companies in the market.

Let’s say mobile application software firms are selling for five-times their sales. Knowing what real investors are willing to pay for mobile software, you could use a five-times multiple as the basis for valuing your mobile app venture while adjusting the multiple up or down to factor for different characteristics. If your mobile software company, say, was at an earlier stage of development than other comparable businesses, it would probably fetch a lower multiple than five, given that investors are taking on more risk.

In order to value a firm at its infancy stage, extensive forecasts must be made in order to assess what the sales or earnings of the business will be once it is in a mature stage of operation. Providers of capital will often provide funds to a business when they believe in the product and business model of the firm, even before it generates earnings. While many established corporations are valued based on earnings, the value of startups often has to be determined based on revenue multiples.

The market multiple approach, arguably, delivers value estimates that come close to what investors are willing to pay. Unfortunately, there is a hitch: comparable market transactions can be very hard to find. It’s not always easy to find companies that are close comparisons, especially in the start-up market. Deal terms are often kept under wraps by early stage, unlisted companies – the ones that probably represent the closest comparisons.

Valuing Startups by Discounted Cash Flow (DCF)

For most startups – especially those that have yet to start generating earnings – the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach. DCF involves forecasting how much cash flow the company will produce in the future, and then, using an expected rate of investment return, calculating how much that cash flow is worth. A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows.

The trouble with DCF is that the quality of the DCF depends on the analyst’s ability to forecast future market conditions and make good assumptions about long-term growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected rate of return used for discounting cash flows. So, DCF needs to be used with much care.

Valuing Startups by Stage

Finally, there is the development stage valuation approach, often used by angel investors and venture capital firms to quickly come up with a rough-and-ready range of company value. Such “rule of thumb” values are typically set by the investors, depending on the venture’s stage of commercial development. The further the company has progressed along the development pathway, the lower the company’s risk and the higher its value. A valuation-by-stage model might look something like this:

Estimated Company Value Stage of Development

• $250,000 – $500,000: Has an exciting business idea or business plan
• $500,000 – $1 million: Has a strong management team in place to execute on the plan
• $1 million – $2 million: Has a final product or technology prototype
• $2 million – $5 million: Has strategic alliances or partners, or signs of a customer base
• $5 million and up: Has clear signs of revenue growth and obvious pathway to profitability

Again, the particular value ranges will vary, depending on the company, and of course, the investor. But in all likelihood, start-ups that have nothing more than a business plan will likely get the lowest valuations from all investors. As a company succeeds in meeting development milestones, investors will be willing to assign a higher value.

Many private equity firms will utilize an approach whereby they provide additional funding when the firm reaches a given milestone. For example, the initial round of financing may be targeted toward providing wages for employees to develop a product. Once the product is proved to be successful, a subsequent round of funding is provided to mass produce and market the invention.

Conclusion

It is extremely hard to determine an accurate value of a company while it is in its infancy stages, as its success or failure remains uncertain. There’s a saying that startup valuation is more of an art than a science. There’s a lot of truth to that. However, the approaches we’ve seen here help in making the “art” a little more scientific.

A Useful Tool

Our Startup Growth Calculator calculates how much funding your startup needs. Assuming your expenses are constant and your revenue is growing, it shows when you’ll reach profitability and how much capital you’ll burn through before then. Check it out and play with it a bit – it’s not a startup valuation calculator, but it will give you an idea of your startup’s financial health.