Valuing your startup is like waiting for the school report card after submitting your favorite science project. Only this time, you’ve labored for years, not a long weekend, and the stakes are so much higher. No one would blame you for feeling emotional and anxious for approval.
But emotions and startup valuations are like oil and water: They don’t mix. To get Acquired, you must approach your valuation like a detached scientist. Collect the data, analyze it, and then compare it with buyer expectations. The market will ultimately decide what’s fair.
The true value of your startup is whatever a buyer is willing to pay for it. Who will your startup most appeal to? A financial buyer Acquires your company to earn a return on their investment. A strategic buyer Acquires your tech, people, or customers to further their company’s goals.
Strategic Acquirers usually pay more, but they’re much harder to find. They’re not interested in financial returns, but in some aspect of your business that complements theirs. As a result, it might take several years of preparation just to appear on a strategic buyer’s radar.
Your likeliest candidate is a financial buyer. To them, it’s all about the returns. Think venture capitalists and private equity firms, for example, or a buyer with expertise your business needs to grow. Understanding a financial buyer’s motivations is the first step in nailing your valuation.
As you might expect, financial buyers have developed a myriad of valuation methodologies and below are five of the most popular. Whether you founded a SaaS, ecommerce, or some other type of startup, start here to demonstrate fair market value for your time, place, and industry.
1. Multiple
Financial buyers prefer industries with similar business models, operating margins, and growth potential. Then they can easily compare startups in that industry for potential acquisition targets. It’s the metaphorical equivalent of squeezing melons at the supermarket to find one that’s ripe.
Of course, you can’t squeeze a startup, but you can compare one to another using a valuation multiple. The financial buyer will evaluate your business and assign it a multiple and then apply it to your profits (EBITDA) or revenue. The final number is what they consider fair market value.
You might also apply a multiple to financial projections, but expect buyers to make your asking price contingent on you hitting projected numbers (called an earnout). Regardless, the multiple is the most influential in your valuation. And choosing that multiple is where things start to get a little complicated.
Generally, the multiple accounts for the specifics of your business. In SaaS, for example, it would reflect your annual growth rate, churn, customer acquisition cost (CAC), lifetime value of customer (LTV), and the quality of your tech stack, people, and upside potential. Multiples can and do vary widely.
When valuing your company with a multiple, buyers tend to look at three things: the quality of your startup, the strength of your performance, and market dynamics. An ecommerce EBITDA multiple, for example, could be anything between 3.1x-14.9x according to one industry report1.
Knowing where your startup sits inside that range depends on countless factors: annual growth rate, web traffic, financials, age, customer retention, inventory (if applicable), and lots more. To help justify your multiple to a buyer, we recommend speaking to an acquisition advisor who knows the market.
Or, you can refer to industry reports like our own multiples report (issued biannually). We collected anonymous, customer-generated transaction data to create a report of the average multiples at which startups got Acquired. The figures aren’t gospel, but they’re a good start.
When Should You Use the Multiple Valuation Methodology?
No hard and fast rules exist here, but a multiple valuation assumes the buyer can compare your business with others that got Acquired. It helps to operate a fairly standardized business model such as in SaaS or ecommerce. You’ll also arrive at a more realistic figure if your startup is at least two years old (proving product-market fit) and generating at least $100,000 EBITDA.
2. Discounted Cash Flow
If someone offered you a million dollars now or two million dollars in five years, which would you choose? I suspect you’d pick the first option. You could do a lot with that one million in five years, including investing it to earn a bigger return than that extra million. Time is money.
Buyers face the same dilemma. How can they ensure that your asking price is a fair reflection of the return they’ll receive in the future? Buyers can answer this question by discounting projected cash flows to their present value in a discounted cash flow (DCF) valuation.
Yes, that’s a bit of a mouthful, and the DCF formula is also a little scary-looking. The premise, however, is straightforward: a buyer determines a discount rate to apply to future cash flow that results in its present value. The buyer then compares the present value with your asking price.
The discount rate is the buyer’s expected return, otherwise referred to as the weighted average cost of capital1 (WACC). If your asking price is lower than the DCF value, your buyer can expect a bigger return. If it’s higher, the expected return is lower so they might drive your price down.
Now, a few caveats: Like a multiple, the discount rate depends on several variables, including the specifics of your startup and the buyer’s investment goals and risk tolerance. It’s also harder to predict future cash flow beyond three to five years. Consider both when using this method.
When Should You Use the Discounted Cash Flow Valuation Methodology?
Any startup with predictable cash flows can use this valuation method. Your buyer has to be confident in your numbers, and it’s up to you to justify them. This could be easy or difficult depending on the complexity of your startup and business model.
3. Cost-to-Duplicate
As the name implies, startups are immature businesses. They might not have made any profits or Acquired many customers. Some might even be pre-revenue. Financial buyers struggle to value these these startups as scant financial data renders their valuation models useless.
However, they can calculate how much it would cost to build that exact startup from scratch, otherwise called a cost-to-duplicate valuation. For SaaS, it could be an engineer’s time spent developing the product. In other startups, it might involve tallying the cost of tangible assets.
In the same way the best seeds don’t guarantee a good harvest, your product or service can’t guarantee a buyer’s return. But that’s not to say your startup is without value. You might not have the customers or revenue, but you invested your time and probably some savings.
The cost-to-duplicate valuation methodology gives you and your buyer a starting point. But it doesn’t take into account your growth potential or intangible assets like goodwill, intellectual property, or brand recognition. You might, therefore, want to factor these into your asking price.
When Should You Use the Cost-to-Duplicate Valuation Method?
You can value any startup this way, but it’s probably better suited to smaller, younger, and unproven startups with little to no revenue and few customers. Think MicroSaaS or other businesses with promising products that have yet to find their markets.
The older the startup, however, the less relevant cost-to-duplicate becomes. You might spend ten years building a product or service, but without paying customers, you’ll struggle to convince a financial buyer your startup is worth the equivalent value of your time.
4. Berkus (or Development Stage Valuation)
Another useful valuation methodology if your startup has little to no revenue is Berkus, named after venture capitalist Dave Berkus2. Rather than value a startup using its financial forecasts, which might be lacking, you value it on its risk factors, split into the following categories:
- Sound idea. Is it scalable, relevant, protected, and proven?
- Prototype. Have you demonstrated proof of concept with a working product or service?
- Quality management. Do you have the skills and experience to grow the business?
- Strategic relationships. How will you leverage partnerships to help you grow?
- Product roll-out or sales. How well can you market your product?
Your startup is then weighted under each category on a scale of $0 to $500,000. Your valuation is the weighting total. If you score top marks, you might earn a $2.5 million valuation. Some financial buyers may widen the weighting scale, too, which could boost your valuation.
Since the Berkus methodology relies only on qualitative data, it’s an excellent choice when your startup is pre-revenue. The missing piece is financial risk – and it’s a big one. Never value your business using the Berkus methodology if you’re already bringing in recurring revenue.
When Should You Use the Berkus Valuation Methodology?
If you’re pre-revenue or otherwise at an extremely early (seed) stage of your business, with little to no financial data available. Qualitative valuations are more like educated guesses, and if you can forecast financial data, you’re better choosing a quantitative methodology or a mixture of both.
Dave Berkus himself said, “I must believe that the candidate company, if successful, could achieve some level of gross revenue at the end of the fifth year in business. Today, for me, that hurdle number is $20 million.” In other words, only use Berkus if you anticipate extraordinary growth.
5. Risk Factor Summation (Similar to Scorecard Valuation)
To become a great chef, you need to know what good food tastes like. You start with an example, usually from the head chef, and then recreate it as best you can. You (and your diners) can then judge your dish – worse, the same, or in exceptional cases, better.
The Risk Factor Summation (RFS) methodology starts with the same premise. You obtain the average valuation of similar startups as your baseline, and then adjust that up or down depending on risk factors such as manufacturing, technology, legislation, reputation, and more.
For each risk factor you measure, you award a score of between -2 and 2, with 2 being the best. Positive scores adjust your baseline up by $250,000 (1) or $500,000 (2). Negative scores reduce by the same amounts. At the end, you arrive at a final valuation adjusted for each risk.
Similar to the Berkus methodology, you can choose alternative values for each score to fit your location and market sentiment. Obtaining the baseline might be tricky since you’ll have to research the market and industry reports to get the numbers. Or speak to their founders.
When Should You Use the Risk Factor Summation Valuation Methodology?
You’ve probably also noticed that this is a qualitative valuation methodology, so the obvious choice is pre-revenue startups and those lacking financial data. Angel investors, for example, often use RFS to decide which startups to add to their portfolio3.
A financial buyer might use one or a combination of the above methodologies to value your startup. Or perhaps another I’ve not mentioned above. No hard and fast rules exist, but if you want to get Acquired quickly, it pays to choose the one that’s most relevant to your startup.
References
1https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/
2https://firstpagesage.com/seo-blog/ebitda-multiples-by-industry/#1649799099090-18d2dba9-33da
3https://www.berkus.com/?page_id=54
4https://blog.gust.com/valuations-101-the-risk-factor-summation-method/
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