Startup Valuation: How to Determine How Much Money You Should Raise for Your Startup

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Raising funds is a complex process that can be one of the most challenging parts of being a founder. Before you begin your fundraising efforts, you need to determine how much money you need to raise. To do that, you need to calculate your startup valuation. Startup valuation is one of the most important things to know when you begin to reach out to investors to raise capital.

There are a lot of things to consider when determining your startup's valuation, from the market trends to the risks to the team behind it. You need to ensure you aren't undervaluing or overvaluing your company while creating an accurate estimate. And that's important to remember, your valuation is just that, an estimate. When you need to raise capital and your company has yet to make revenue, how do you determine your company's value?

What is Startup Valuation?

Startup valuation is what your startup is worth, depending on a number of factors. It's the process in which founders analyze data and research to determine the worth of their startup at the time when they need funding. This is done through several different methods and calculations to come up with a figure as accurately as possible.

It's important to get as close to accurate as possible when determining your company's valuation because investors decide to invest in startups based on the value and potential of the business. Investors want to be able to accurately calculate their return on their investment, and in order to do that, they need an accurate valuation to work from.

7 Effective Methods to Determine Startup Valuation

Calculating your startup value, while an estimate, requires some research and analysis to help you make an accurate determination. There are a few startup valuation methods to consider when determining your startup valuation.

1. Berkus Method – The Berkus Method was created by angel investor and venture capitalist Dave Berkus. It looks at valuing a startup through a detailed assessment of five key factors of success: Basic value, technology, the management team (execution), strategic relationships, and production. It's a method designed to quickly assign value based on a few factors alone. It assigns a value ranging from zero to $500,000 for each area.

  • Basic Value $0 – $500,000: Is the idea exciting and innovative?

  • Management Team $500,000 – $1,000,000: {' '} Is there are strong management team behind the startup?

  • Prototype $1,000,000 – $1,500,000: {' '} Is there a product created or a viable prototype that is attracting customer attention?

  • Strategic Relationships $1,500,000 – $2,000,000: {' '} Are there strong relationships and partnerships to help develop the startup?

  • Production $2,000,000 – $2,500,000: {' '} Does the startup have traction or a path to profitability?

2. Scorecard Valuation – One of the more popular methods is the Scorecard Valuation Method or the Bill Payne Method. This method works by comparing similar startups that are already funded at the same stage as your startup. There are other factors you need to consider when using this valuation method.

  • Management Team 0-30% – Does the founding team have a strong background and a lot of industry experience?

  • Market Size 0-25% – How big is your market size, and do you have many leads interested in your product or service? The bigger the potential market is, the more likely you'll have ready buyers.

    • Traction – Has your company made any traction? Traction is a measure of your startup's growth in the early stages. When you're pre-revenue, it doesn't have to be your sales. It can be a wait list, people who have prepurchased, or a strong following through social media. It's a measure of proof that your company will grow.
  • Product and Services 0-15% – Do you have a minimum viable product, a working prototype, or strong, smart tech to back your product or service. The more progress you have made in building or getting ready to go to market, the higher your valuation will be.

  • Competition 0-10% – Is the market saturated in your industry? If you have a high level of competition, it will make it challenging to stand out.

  • Marketing and Growth 0-10% – If you can show your user base is growing, and people are engaged, your company valuation will be worth more.

  • Need for Other Investments 0-5% - Does your startup potentially need more investments or investors?

  • Other 0-5%

3. Venture Capital Method – The venture capital method is a simple two-step process made popular by a Harvard Business School Professor, Bill Sahlman. The process looks at two valuation formulas when your startup is pre-revenue:

  • The Terminal Value During the Harvest Year {' '} – The terminal value is the expected value of the startup on a date in the future or when an investor exits the startup, also called the harvest year. The calculations will use the estimated or projected revenue, profit margin, and the industry P/E ratio or stock to price-earnings in the harvest year. Terminal Value = projected revenue x projected margin x P/E.

  • The Expected Pre-Money Valuation{' '} – For the pre-money valuation of the venture capital method, you need to determine the required ROI and the investment amount. The formula used is Pre-Money Valuation = Terminal value / ROI – Investment amount.

4. Comparable Transactions Method – The comparable transactions method determines similar startups similar to yours that were acquired. The research into these startups helps determine similar startups to yours that have been acquired and for how much. While this method is popular, you need to carefully look at a lot of factors of comparable startups, such as market conditions to know if the startup conditions match yours closely or are too vague.

5. Cost-to-Duplicate Method – The cost-to-duplicate method evaluates the assets of the startup in the current state and calculates how much it would be to duplicate the business in another market. This method calculates the fair market value of your physical assets, research and development costs, patents, prototype costs, and more. You will want to include any costs that have gone into building your startup and getting it to its current point today.

6. Risk Factor Summation Method – The risk factor summation creates a more detailed valuation. It looks at the risks of the investment of your startup by calculating the valuation using an existing method and subtracting $250,000 based on the risks that might affect the ROI. The lower the risk, the better the grade of your valuation. Some of the common risk categories include:

  • Management

  • Capital accumulation

  • Technological risk

  • Legal or Litigation

  • Pollical risk

  • Manufacturing

  • Competition risk

This valuation method allows you to review the probability of success for your startup by adding or subtracting from the average value depending on how many risks impact your business in a certain category.

7. Discount Cash Flow Method – The discounted cash flow method focuses on forecasting your startup's future cash flow. Once you have a forecast, you then apply a discount rate or the expected ROI. The higher the discount rate, the riskier the investment is to investors. For startups just getting started, the discount rate will be much higher, signifying a riskier investment to investors.

Common Valuation Mistakes
Determining your startup valuation is complex and requires some guesswork. There are bound to be some mistakes along the way. The more you know about what to expect, the better prepared you can be to ensure mistakes don't impact your ability to get funding for your startup.

Not Doing Research – You need to do your research to get a realistic idea of what your startup can be valued at. Potential investors are going to do their own research before they decide to invest. You want to be sure you are presenting actual figures and data that helped you come up with your valuation.

Don't Overestimate – Founders are proud of their startups and what they hope to accomplish. However, you don't want to list your startup at the highest valuation possible. It will be hard to deliver on those expectations and strain your relationship with your investors, cause you a lot of stress, and potentially damage your reputation.

Remember Your Valuation is Not Permanent - Your startup's value is going to consistently change throughout your development. You need to perform a regular valuation on your startup as you grow before you begin your next round of funding. 

You need an accurate startup valuation to present to investors to justify your value and funding needs. There is no perfect valuation method and remember that mistakes will be made. Try out a few different methods to ensure you come up with a number that is as accurate as possible to prevent mistakes that could be catastrophic to your fundraising efforts. By perfecting your valuation method, you can ensure your fundraising strategy is developed and prepared for presentation when you're ready for the next round.

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