Not long ago, the world looked rosy for many startups. Capital was available in abundance, costs were relatively easy to plan, and the growth potential for many digital business models was great. Those days are over for now. The circumstances have become much harsher and do not only affect those startups that already rely on external financing. Cost increases, interest rate hikes and major uncertainties in long-term planning are also causing problems for bootstrapped startups. Therefore, many founders are considering new financing options and ask themselves whether they should bring external investors on board - and under which conditions.
Before negotiating with potential investors, the first thing that is needed is a valuation of the startup, and it should be as realistic as possible. The problem here is that the younger the startup, the more difficult it is to make such a valuation. While valuations of mature companies are determined based on hard key figures, this is not possible with young startups. Usually, they still make little revenue, no profit at all, and often there is not even a mature product.
And still, the valuation is necessary. So how exactly can it be calculated and what factors influence it?
Methods to value a startup
There are many practices to determine the valuation of a startup. Here are three of the most widely used methods:
1. Discounted Cash Flow (DCF)
A widely used approach is the DCF (discounted cash flow) method. The name describes the core of it: Based on the current cash flow, a forecast of the future cash flow is made and then "discounted" by a fixed discount rate, because a cash flow forecast for a few years from now is worth less today due to factors such as inflation and interest rates.
Advantage: Those who use this method must take a close look at their business model. One of the disadvantages is the difficulty to apply it to startups with a high degree of planning uncertainty. Generally, it only works for startups with a positive cash flow - but that is not always the case. Overall the DCF method is more suitable for later stage startups.
2. Market Multiple or Market Comparable
Here, comparable companies with publicly available key figures such as revenue, EBITDA, ARR multiple or net profit are used for the calculation. Based on these figures, an estimated value for the valuation of a startup can be determined. The biggest problem with this method: Especially for young startups, it is not easy to find comparable companies with public key figures (or even those with a similar business model). Factors such as profitability or sales targets cannot be included here either. On the advantage side, the method is very practical and the application is relatively simple.
3. The Venture Capital Method
This method is used by many VC companies. It combines the DCF and the multiples methods and focuses on the planned exit. From the startup’s estimated future purchase price, it is calculated back to the present day to obtain a valuation. The startup’s liquidity requirements and the return expectations of the investor as well as the time required until the exit are taken into account. The method is comparatively simple to apply and suitable for early growth phases. The main disadvantages: Although it provides more reliable results for the valuation of startups than the DCF and the multiples method, it is still rather inaccurate. In addition, it uses multiples for calculation, which refer to comparable exits in the past, but are applied here to a planned exit in the future. This can only lead to approximate values.
These are just a few examples of widely used methods, and there are many more. Unfortunately, none of them is a "one size fits all" solution, they can only provide approximate values. They are also often combined with each other. Experts and dedicated consultants can help on a case-by-case basis to find the most appropriate method for valuing a startup.
These factors influence startup valuations
There are different factors that have an impact on the valuation of a startup. Many of them relate to characteristics of the company and team, others to the market in which the company operates. In addition, a distinction can be made between quantitative and qualitative factors.
Among the quantitative ones are the following:
- What is the startup's growth rate?
- How many customers does it have already?
- How high is the ARR?
- What does the cost development look like?
Qualitative factors include the following:
- The founding team: How much know-how, network and experience does it bring to the table?
- How unique and innovative is the product? What stage of development is it at, what is the value proposition, what is the product market fit?
- How scalable is the business model and how great is the growth potential?
- How effective are the marketing measures?
- How attractive and promising is the market in which the startup is positioned?
- What is the current and future regulation of the market and what impact does this have on the business model?
- How is the competitive situation?
- What is the general economic situation, especially with regard to VC funding? In recent years, VCs have sometimes been queuing up to invest in startups. That has changed significantly over the course of 2022. Whether VCs want to invest money or whether they are more reluctant to do so, impacts the level of a startup’s valuation.
Pre-money and post-money
Another important difference, which should be mentioned here only briefly, is between pre-money valuations and post-money valuations. In the case of a pre-money valuation, the capital inflow to date is not included. In a post-money valuation, the last financing round is included in the company value. In the second case, the valuation is naturally higher. The decision for one of the two methods can have a great influence on the ownership shares in a startup.
What to do in case of a low valuation?
Sometimes the odds are against a good valuation. This is often the case in phases of recession or in an otherwise difficult economic situation. Or the market in which the startup is active is going through a bad phase. So timing is extremely important and can have a big impact on how a startup valuation turns out.
For SaaS companies that are currently in such a phase, a financing with re:cap can be a good option. re:cap, helps extending their runway, so startups can postpone the next funding round to a later date when strong growth has led to a better valuation.
But not only then is re:cap a good alternative to other forms of financing: Bootstrapped startups can use re:cap to raise additional capital without diluting their shares.
Startup valuations are complex and only offer approximate values. They should therefore be used as a basis for negotiations with investors and less as exact mathematics. In practice, it is often the case that startups are more likely to agree to a slightly lower valuation with an investor who is a great fit and has an excellent reputation and network. It may well be advantageous to bring in experts and consultants to assist with the initial company valuation.