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How to Valuate a Start-up?

Have you founded a company, and don’t know how much it could actually be worth? Or are you maybe  a Business Angel considering investment into newly founded business, who needs to estimate its value?

Start-ups valuation methods I’d like to share with you can be supportive in both of the   situations. I will focus on valuation of early stage technology start-ups, and so called pre-seed valuation, which refers to the stage of a company before it attracts any external funding such as Business Angel, or Venture Capital. For later stage start-ups, especially those which attracted funding, you should use a different valuation methods . By technology start-ups I mean start-ups, which build their value thanks to owned intellectual property rights, which consists of non-obvious know-how, industrial designs, and patents.

For applicable purposes of this post let’s assume you are a CEO of a start-up, who prepares to meet with its potential investors. The question you ask yourself is how much your company is  worth, and how much you should ask for, which always will be a derivative of your company’s valuation.

Whereas old, good, and favored by Venture Capitalists multiplies method, or Discounted Cash Flows (DCF) method needs to base on solid or well educated market size and your sales projection, it cannot be used in all examples, and sometimes it’s just inadequate to use. Such cases include creating new product or service entering new market of unmet needs, which you cannot back up with any solid benchmark. For sure you can make your own assumptions, do primary and secondary market research,and check flexibility of demand of your product or service against proposed price, however it’s good to have back up valuations, especially when your DCF is challenged by investors you negotiate investment with.

Seriously thinking investors can check value of your company against couple of pre-seed valuation methods, which are currently in use. One of my favorite methods, which I learned from serial entrepreneurs Prof. Malte Brettel from RWTH Aachen in Germany, and Prof. Tony Warren from Pennsylvania State University in the US, is Berkus valuation model.

Berkus valuation model comes from the US, and is especially valuable when you lack financial history, your business plan is uncertain, and still you need to determine value of your company. According to Berkus valuation model you need to check the existence of, and add up values for the following elements, which your start-up might consist of:

1) Sound idea your start-up represents (creation of basic value)  – add up to USD 500 k

2) Having prototype (reduction of technology risk) – add from USD 500 k to USD 1 mln

3) Having good management (reduction of execution risk) – add from USD 500 k to USD 2 mln

4) Having strategic relationships (reduction of marketing risks) – add from USD 500 k to USD 2 mln

5) Having good quality of the board, incl. advisors (reduction of governance risk) – add up to USD 1 mln

6) Having ongoing sales (reduction of production risk, doesn’t apply in very early stage) – add up to USD 1 mln

Berkus valuation model originates form Dave Berkus, early stage private equity investor, who made over 140 technology investments. Original Berkus method assumes fewer factors and sums tan provided in method above, and if you are conservative entrepreneur, you can stick to orthodox approach of Berkus presented here.

You can make Berkus method even more pragmatic if you combine it with Kawasaki method, also used for early stage start-ups valuation. In a nutshell  Kawasaki’s method introduces additional element you can add to Berkus, this is value you add for each engineer on board of your start-up  – USD 500 k, and value you subtract for every full-time MBA on board (such as top management consultants) – USD 250 k. In that context it’s always better to ask full-time MBAs to join the advisory board of your start-up, and present them as non-core staff, as they cost a lot, and increase the monthly burn/run rate of early stage venture. It doesn’t mean that full-time MBA start-up founder by definition decreases value of the venture of course.

You can complement both Berkus’ and Kawasaki’s valuations with Cayenne Valuation Method . Cayenne Valuation Method is based on 25 questions, which High Tech Start-up Estimator of Cayenne Consulting consists of.

Other early stage start-up methods include angel’s standard method, rule of thirds method, start-up advisor method, or virtual CEO method, however these I detailed above seem to be the most substantial in terms where the numbers you present comes from.

If you’re determined and not afraid to learn it’s good to master basic DCF method. Sooner or later you’ll need it, especially when you start growing in a way requiring investments more serious than from Business Angels. I’ve learnt DCF from Principles of Corporate Finance by R. Braeley, S. Myers and F. Allen therefore I can recommend it to you. You can find some basic information about DCF here

However if you are real entrepreneur you should find someone who is DFC-literate to support you, including your peers who graduated from economics, finance, or business studies, worked for top management consulting or valuation practices in other consulting companies.

Don’t start valuation of your company with DCF if you don’t have thorough business plan of your venture in the first place,  especially including industry, market forecast, and marketing plan detailing targeted market segment, envisaged pricing of your products, and/or services, promotion, distribution, first five years sales projection, and also production and operations plan. You’ll need this data as assumptions for state of the art DCF valuation every potential investor thoroughly investigates.

In that context you might find supportive basic financial model template and early stage pitch deck template prepared by Amplify, which is one of US start-up accelerators I researched for my Master Thesis at MBA Entrepreneurship and Innovation in WU Executive Academy.

Dzida!

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