5 commonly used methods VCs use to value startups

How do VCs value startups
How do VCs value startups

Presented as part of venture capital content series in collaboration with Zayn Capital.

Valuation is the process of determining the economic value of a startup by assessing various factors such as future potential cash flows, the value of assets, the competence of management, and historical performance. 

However, in the case of newly established startups, calculating valuations can be difficult. Startups do not have much historical performance data on which investors can gauge their future potential and, thus, their current value.

It is critical to understand that the value and price of a startup should not be confused. A startup’s value may be greater or lesser than its price. If the value is less than the price, we consider the startup overvalued and vice versa. 

Knowing the valuation of your startup will help you negotiate with venture capitalists for more funding on more favorable terms.

In this article, I’ll go over five commonly used methods venture capitalists use to value startups in Pakistan:

SAFE (no-cost round)

Calculating a newly initiated startup’s valuation can be challenging because of the limited historical data available. Under such circumstances, investors use SAFEs (Simple Agreement for Future Equity) to invest in the business without deciding on a valuation for the startup at that moment. 

In the future, when the startup requires additional capital for expansion and growth, it will hold additional funding rounds. When the startup completes a priced round with a set valuation, all previously executed SAFEs will be converted into startup shares.

The Berkus Method

Under this method, the pre-money valuation of your startup is calculated based on the quality of various value drivers, both qualitative and quantitative, such as:

  • Soundness of the business idea
  • Prototype of products or technology
  • Competence of the management team
  • Professional and strategic network
  • Historical financial performance and future strategy

Venture capitalists closely scrutinize these factors to reduce risks in terms of market, technology, production, competition, and execution to improve their chances of achieving successful exits. 

For each factor listed above, venture capitalists typically assign a value between $0 and $500,000. As a result, your startup’s pre-money valuation could reach $2.5 million under this method. 

To better understand this concept, consider a newly established fintech startup, “Pak Pay,” which provides digital payment and transfer services. 

Pak Pay’s product is a digital application that provides payment and transfer services to its customers. 

Considering the information above, we can calculate the pre-money valuation of Pak Pay as follows:

Value DriversValue Range (in millions)Value Assigned (in millions)
Soundness of business idea$0 – $0.5$0.4
Prototype of products or technology$0 – $0.5$0.35
Competence of management team$0 – $0.5$0.4
Professional and strategic network$0 – $0.5$0.35
Future strategy$0 – $0.5$0.3
Total Pre-Money Valuation$0 – $2.5$1.8

It is important to note that the Berkus method would no longer be applicable once a startup begins to generate revenue. In practice, the hypothetical maximum valuation of $2.5 million is adjustable based on valuations in that market.

Comparable Valuation Method

Under this method, venture capitalists calculate a startup’s valuation by considering various market multiples of comparable companies.

The most commonly used multiples are the enterprise value (EV) to revenue multiple and the EV to EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples. 

EV-to-revenue multiples are used for early-stage startups that are incurring losses. However, both of the multiples above can be used for later-stage startups that have become profitable over time.

Similarly, companies with a similar business model to yours can be considered comparable under this approach. These businesses may be competitors, suppliers, or customers.

The first step in calculating a startup’s valuation using this method would be to compile a list of comparable companies and then calculate their individual EV/revenue and EV/EBITDA multiples.

Calculating these multiples would be simpler in publicly traded companies with audited financial statements on their websites and shares traded on stock exchanges. In the case of publicly traded companies, we will use the previous year’s revenues and EBITDA. Furthermore, EV can be calculated using the formula:

EV = Market Capitalization + Market Value of Long-Term Debt - Cash and Cash Equivalents.

On the other hand, calculating the same multiples for unlisted companies will be relatively more difficult because their data is not easily obtainable.

However, several platforms (including Techshaw) report on funding rounds completed by various startups and inform the public about their operational and financial performance. Investors could use such platforms to obtain the necessary data and calculate the multiples above for comparable unlisted companies.

Once we’ve calculated the multiples for comparable companies, we can assign weights based on how similar their business models are to the startup being valued. The next step would be to compute the mean of the weighted multiples of the comparable companies listed in the previous step.

Let’s take Q Mobile as an example. Based on the information given above, Q Mobile’s valuation can be calculated in the following way:

Comparable CompaniesRevenue (in millions)EBITDA (in millions)EV to EBITDA MultipleEV to Revenue Multiple
One Plus$18$1.44231.8
*All figures above are fictitious and are used for illustrative purposes only.

Now let’s assume that Q Mobile has been operational for three years and has generated revenue of $18 million and an EBITDA of $1.5 million in 2021. Based on this information, Q Mobile is worth $27.9 million using the EV to EBITDA method and $27 million using the EV to revenue method.

Scorecard Valuation Method

This method evaluates newly established businesses by comparing them to similar businesses in the same region or industry. Investors and venture capitalists calculate pre-money valuations of other similar companies. Then they use the average pre-money valuation of those companies as a benchmark to calculate a startup’s pre-money valuation.

Investors then assign a percentage to the startup based on metrics such as technology or product quality, potential market size, and management competence compared to the average startup. These metrics are weighted according to their importance in your business. For example, if your startup manufactures and sells mobile phones, the quality of the technology and products sold may be given greater weight.

The average percentage assigned to the metrics is 100%, with a score greater than 100% indicating that your startup is performing well on a specific factor and vice versa.

The value factor would be the sum of the individual weights and percentages assigned. Multiplying this value factor to the average of the pre-money valuations of comparable companies would give us the assessed valuation of your startup. 

To understand this concept better, let’s continue with the previously discussed Q Mobile example.

Furthermore, the average pre-money valuation of new mobile manufacturers is $10 million. 

In this case, the pre-money valuation of Q Mobile will be computed as follows:

Performance MetricQ Mobile Score (%)Assigned Weight (%)Value Factor (%)
Potential market size1203036
Competence of management1502020
Quality of products and technology1302026
Level of competition1101516.5
Miscellaneous factors801512
Total Score590100120.5

According to the above calculations, Q Mobile outperforms the average of newly established mobile manufacturers in Pakistan, as its total score is greater than 100% and comes in at 120.5%. 

Hence, Q Mobile’s pre-money valuation is $12.05 million, which is the product of 120.5% (the total score of Q Mobile as per assigned metrics) x $10 million (the average pre-money valuation of comparable newly established companies). 

Venture Capital Method 

The Venture Capital method differs from the previous approaches discussed in this article. Rather than using various metrics to determine your startup’s pre-money valuation, the Venture Capital method determines a startup’s post-money valuation first while keeping various industry metrics in mind.

The two main drivers while calculating a startup’s post-money valuation are the expected return on investment (ROI) and terminal value. 

Terminal value refers to the value of a startup at a future date. For example, if Q Mobile is expected to be sold after ten years, its calculated value will be considered its terminal value in the tenth year. The terminal value of Q Mobile can be calculated by estimating how much revenue it will generate in its tenth year of operation.

Assume Q Mobile is expected to generate $10 million in revenue in its tenth year of operation, and the industry-standard price-to-revenue multiple is 5x. Q Mobile’s terminal value is expected to be $50 million in this case. 

The next step is to gauge a startup’s expected return on investment (ROI). The ROI will also differ depending on the industry. Assume that the average ROI for mobile manufacturer startups in Pakistan is 15x. 

We can now compute Q Mobile’s post-money valuation. The post-money valuation formula is as follows:

Post-money valuation = terminal value/expected ROI.

Using the formula above, Q Mobile’s post-money valuation will be around $3.3 million. 

Suppose Q Mobile requires an investment of $800,000 million from investors for expansion. In that case, its pre-money valuation will be $2.5 million (the difference between Q Mobile’s post-money and the current capital required from investors).

Three Key Takeaways

  • Valuation estimates a startup’s economic value by evaluating various aspects such as future prospective cash flows, asset value, managerial competence, and previous performance.
  • A startup’s value and price should not be confused. A startup’s value may be greater or less than its price. If the value exceeds the price, we believe the startup is undervalued, and vice versa.
  • Investors should use multiple valuation methods to reduce the margin of error between a startup’s true and expected value.

There is no single way to value startups accurately. Further, valuing startups involves using pure judgment and foresight about how they’ll do in the future compared to specific benchmarks.

Strategic Acquisitions & Investments (M&A) professional with a strong interest in strategy, private equity, and venture capital in Pakistan. I have a Bachelor’s degree in accounting and finance from Lahore University of Management Sciences (LUMS).
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