How Not to Overvalue a Startup?
2021 startup overvaluation boom
Valuation is a combination of art and science. In 2021 it was more about art.
As we mastered Zoom and embraced remote work, venture capitalists were busy showering startups with billions of dollars like it was a money storm. It’s been a wild ride where cash flowed freely into the startup universe.
But now, we’re noticing that many of these startups, which skyrocketed during the pandemic, are overvalued. And this over-the-top valuation has left these baby companies wobbling, possibly putting a lot of jobs in the danger zone.
To not overvalue your startup, we’ll check out the best ways to do it in simple terms.
What is a startup valuation?
Startup valuation is like figuring out the price tag for a startup, keeping in mind the market factors of its industry and sector. Famous VC Fred Wilson says it’s not always about the here-and-now value of a business, as businesses with small revenue and projected losses can still have a high value. Venture capital deals often come wrapped in convertible preferred stock investments, which, if a business flops, turn into something more like dept.
A startup’s valuation is like its price at a specific moment. Valuation ingredients include:
- the development level of the product or service;
- how well the idea works in the real world;
- the head of heads (CEO) and their crew;
- how much other similar startups are valued;
- relationships and customers;
- and, of course, sales.
An accurate valuation of your startup is critical because if you overvalue it, investors likely won’t give you any money.
On the other hand, undervaluing your startup means you’re giving up a lot of equity for less money or undervaluing what you have built so far.
Getting your startup’s valuation just right is super important because if it’s too high, investors might keep their wallets shut. But if it’s too low, you could be tossing away a lot of equity and money or not giving enough credit to what you’ve created so far.
Why startups are often overvalued
To grasp why inflated valuations are problematic, we need to first examine the underlying mechanism at play. Unlike public companies with fluctuating valuations, startup valuations usually only change after a new funding round closes. Calculating a startup’s new value is quite simple: new valuation = (share price at latest round) x (total number of company shares).
This is called the post-money valuation model, which is widely accepted as the industry standard.
Though this method might seem like the most rational way to value a business, it can sometimes inadvertently overstate a company’s true worth, even when the investor’s share price is reasonable. This occurs because not all shares are created equal.
The ways to evaluate your startup
There are some methods to value your startup. You should start using them from the pre-seed stages and better check with the professionals. CGS-team has a whole team of business analysts, creating estimates, boosting ideas, and minding your business logic and numbers.
- Berkus Method
The Berkus valuation method allocates a value to the business concept and the company’s 4 main success drivers. Each category can contribute up to $500,000. In its original form, the Berkus Method permits a maximum valuation of $2.5 million (including revenues) or $2 million (excluding revenues).
- Sound Idea (basic value)
- Prototype (reduces technology risk)
- Quality Management Team (reduces execution risk)
- Strategic Relationships (reduces market risk)
- Product Rollout or Sales (reduces production risk)
source: Galablynx
- Venture Capital
A basic startup valuation method calculates the value by looking at the future worth of the startup and the investor’s desired return (like 10X, 8X, etc.). The formula is: Pre-Money Valuation = Post-Money Valuation - Invested Capital The Post-Money Valuation is the future worth divided by the expected return. For example, if an investor thinks your startup will be worth $1,000,000 and wants a 20X return on their $10,000 investment, your Post-Money valuation is $50,000. So, the Pre-Money Valuation is: Pre-Money = $50,000 - $10,000 = $40,000
- Projection
Projection is made by comparing the startup you want to value with similar companies in the market. You can use public industry data like CB Insights and PitchBook or ask for help from startup founders and investors you know who have experience with similar projects. While this method doesn’t involve exact calculations, it’s usually the best option when there are no numerical data available.
- DCF
Discounted cash flow (DCF) is a valuation technique that calculates an investment’s value based on its anticipated future cash flows. It takes into account the time value of money, which assumes that a dollar you have today is worth more than a dollar you’ll receive tomorrow since it can be invested.
The formula looks like this:
source: Investopedia
- Multiples
For startups making money and showing profits, the Valuation by Multiples method is popular.
Imagine your startup has an EBITDA* of $250,000. An investor might value your business at 5X, 10X, or 15X your current EBITDA based on factors like your industry, competitors, management team, and other aspects. This easy-to-use valuation tool helps investors quickly estimate the value of a more developed startup.
*EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and it’s a widely used indicator of a company’s financial health and cash-generating ability.
- Cost-to-Duplicate
The Cost-to-Duplicate method for valuing startups is quite simple, focusing on the costs and expenses involved in building the startup. It estimates the cost of recreating the company from the ground up.
However, there are some drawbacks:
- It doesn’t consider the company’s future potential, such as future sales and growth projections.
- It overlooks intangible assets along with physical assets. Even at the startup stage, intangibles like brand value, goodwill, patent rights (if any), etc., can significantly impact a company’s valuation.
Startup stages
- The seed stage (pre-seed and seed)
It involves financing to bring the idea to life.
Seed funding: Usually provided by founders, friends, or family members.
Angel funding: Seed investors and others contribute more capital for marketing and customer acquisition.
- Series A funding
This early Growth Stage round provides capital to test the business model in the market. Typically, Series A rounds finance $2-$5 million.
- Series B funding
Also an early Growth Stage round, funds are used to refine the business opportunity, build a strong team, and develop the product or service. Typically, Series B rounds finance $5-$15 million.
- Series C funding
Investors support the venture when the team, product, and customer base are established and it’s time to scale. The startup may expand globally, diversify offerings, or broaden distribution channels. Typically, Series C rounds finance $15+ million. Companies raising Series C or beyond indicate they have achieved critical mass for viability.
source: CloudWays
Valuation methods for different stages
Here are what valuation methods we can use for different funding stages:
Ok, so...
We’ve discussed valuation methods, funding stages, and why startups are often overvalued. Though it may look like a more sweet offer for investors, it causes significant problems in the future. If you don’t want to become the badly famous founders from Forbes covers, take the methods listed above and be fair and have a reliable partner on your side, minding everything from your numbers to your design.