Thanks to the buzzwords in the world of entrepreneurship, “startup” is now one of the most widely used terms in the world of accounting and finance. But what does it mean? A startup is a new business that wants to grow on the basis of its idea.
Since startups are just like young business models, they need capital to grow. But raising money isn’t an easy task because it involves people who will be investing their hard-earned money. To raise capital, all startups go through a valuation process.
In today’s blog post, we’ll explore the world of startup valuations. So, with that being said, let’s jump in and learn all about startup valuations in accounting and finance.
What Is a Startup Valuation?
Startup valuation is a process that involves calculating the value of a startup company. From office space to business idea and inventory - pretty much everything is calculated to approximate the total value of the startup.
Business owners always try to sketch up the startup value at a high stake. In comparison, the investors prefer a low value so they can get a more significant return on their investment.
As a startup doesn’t have any accounting, finance, and tax records or a steady stream of revenue, it’s hard to calculate its value. Mature business valuation uses the good old EBITDA formula, which isn’t able to calculate the worth of startups.
However, there are some professional methods that can be used to calculate the value of startups. More on popular startup valuation methods in the next section.
Popular Methods of Gathering Startup Valuation
Experienced angel investors, venture capitalists, and entrepreneurs have created some methods that help gather any startup’s value quickly and easily. So let’s check out some of the popular methods of startup validation.
Berkus method is a simple and straightforward startup validation method that’s based on five fundamental principles. Each principle is assigned a maximum value that can be earned to form a valuation. The following are the five qualitative elements that are valued for a startup’s worth:
- Sound Idea
- Quality Management Team
- Strategic Relationships
- Product Rollout or Sales
Now an investor or a CPA who gathers the startup value can add the desired amount to each principle. Lastly, add up everything to get the total estimated value of a startup.
Venture Capital Method
The concept of VC or Venture Capital was introduced by Professor Bill Sahlman at Harvard Business School back in 1987. This method uses the following two formulas for predicting the pre-money valuation of pre-revenue startups.
- Post Money Valuation = Terminal Value / Anticipated Return on Investment
- Pre-Money Valuation = Post Money Valuation - Invested Capital
For instance, the investor values your startup at $4 million and wants 20x returns of its $100,000 investment. In this case, the Post Money Valuation would be $200,000. Using the VC formula, we will subtract the Invested Capital from the Post Money Valuation that gives us $100,000 in the Pre-Money Valuation.
The Cost-To-Duplicate method is one of many CPAs’ most popular methods to determine a startup’s value. This method’s main goal is to determine how much it would cost to start the same business or startup from scratch.
This method has a very realistic approach to gather the actual value of startups. If the cost of duplicating the same startup is low, then its value will be near to nothing. If it is complex to approach the startup’s business model, then its value will automatically increase.
In the comparables method, a startup is valued by approaching its referential information and the numbers from other similar transactions. For instance, a similar application, just like the startup, is valued at $10,000,000, and it has around 200,000 users or subscribers. This means that the company is valued at somewhere around $50 per user. A smart investor could use this benchmark to value the startup’s worth he is looking forward to investing in.
Now we know about some popular methods of valuing a startup; let’s finish with learning why startup valuation is important.
Importance of Startup Valuations
For the founders, their startup without any investment or capital will surely fail. And to investors, it would be risky to invest in any unknown startup. That’s why a startup valuation is essential so that both investors and founders can learn about the actual worth of startup.
Using the startup valuations methods, an investor or a founder can easily sketch up the estimated worth of the startup. It will assist both parties to grow the startup into a profitable source of income.
If you are a startup owner, startup valuation is necessary to help your startup pick up the pace in its early stage of investment. As an investor, startup valuation helps you to see the future of the startup, but for both parties, startup valuation is a necessary process. If you need help putting together your accounting records so that you can get a more accurate view of your valuation, take advantage of a free consultation call with Josh Hall. From tax filing strategies to tips on bookkeeping and accounting, J. Hall & Company has you covered.