Why Does a Startup Need Business Valuation Services?
Business valuation in Arizona is a crucial step for startups seeking capital to accelerate their service provision. This article examines the importance of business valuation, methods, and limitations. So, let’s get into it.
Why is startup valuation important?
A startup can only develop its concepts when it has enough capital. A startup with insufficient capital is destined to fail. Raising money is necessary to warrant a startup’s success, besides growing your company’s technical and managerial side.
Startup valuation is an approximation that yields a relative number, signaling the growth potential of a young company. While the approximation gets outdated quickly, it enables investors to make informed decisions.
An investor might want to size their investment according to the expected returns. In contrast, corporate venture capitalists might want to access the startup’s innovation rather than benefit from fast growth and exit.
Besides, a startup needs capital for hiring staff, office space, marketing, prototyping, etc. Estimating your startup’s value is the only way you can approach an investor for funding. There are several startup valuation methods valuators use.
Startup valuation methods
The Berkus method is the brainchild of Dave Berkus, a venture capitalist whose main aim is to find the value of pre-revenue startups. The method identifies and studies five crucial startup areas and assigns a dollar amount ranging from zero to $500,000. They include:
A soundidea: The company has a brilliant business idea.
Quality management team:The business has an efficient management team.
Prototype:The firm has a working product that attracts clients.
Strategic relationships: The business has robust partners in its industry.
Product sales:The company shows future growth potential.
To calculate the pre-revenue value, the method adds up to $500K for each area. It allows investors to do precise valuations and not base them on projected revenues. The theoretical pre-revenue and post-revenue valuations should not exceed $2 million and $2.5 million, respectively.
Scorecard valuation method
The scorecard valuation is another popular method for startups in Arizona. It compares your startup with similar startups which have received funding with added criteria, comparing areas such as region, market, and stage. Once investors come up with a valuation, it will help them decide how much they can invest in your business.
They will compare the following qualities and assign a percentage depending on your startup’s performance.
Product or technology: 0-15%
Need for additional funding: 0-5%
Marketing and sales: 0-10%
You’ll then assign a comparative percentage for each quality. Ideally, you can be at par (100%), below average (< 100%), or above average (>100%). For example, if Company A has a strong team than its competitors, you can give it a 140% comparative percentage.
You’ll multiply 30% by 140%, getting a factor of 0.42. Sum the total of each quality to get the value. Finally, multiply the total by the average valuation in your business sector. It will give your company’s pre-revenue valuation.
Discounted cash flow method
If a company in Houston is insolvent, it cannot use the member’s voluntary liquidation; instead, it uses the creditor’s voluntary liquidation (CVL). While a voluntary method, company directors use it as the last resort when options are few. If the company decides on CVL, it is best to seek professional advice before debts escalate.
The company will first inform the shareholders before appointing a professional insolvency practitioner. Once selected, they take charge of the process, ensuring the company winds down legally. The firm’s assets will be sold, with the funds extracted used to repay the company’s creditors.
The company’s shareholders will receive the remaining amount, if any. The director will pay the insolvency practitioner’s fee. And if there’s no money left, they will have to pay from their pockets.
A startup can also use the discounted cash flow (DCF) method. However, it is advisable to consult the services of a professional when using the method. Simply put, DCF is a valuation method that estimates a startup’s value using its projected future cash flows.
In short, it determines the current value of a firm based on projections of how much money it will generate in the future. Investors will take the projected future cash flows and apply a discount rate. If the discount rate is higher, it signals a risky investment.
This method’s chief advantage is that it enables investors to determine whether an investment is worth the salt. Besides, its projections can be adjusted to provide results for different scenarios. The downside is that it relies on future predictions and not actual figures. One needs to estimate the discount rate and cash flows correctly.
As the name suggests, most venture capitalists in Arizona use this method to value startups. It aims to reflect the mind of an investor looking to exit at a specific time, ideally between 2 and 5 years.
The VC method will multiply the expected earnings with market multiples such as the PE ratio. The total is the equity value at the end of the specified period.
The estimated value is then discounted back at a target rate of return, which is set high to capture a business’s risk. There are, however, some limitations to this method. For one, it uses a short forecasting period and multiplies of comparable companies, which are also based on future cash flows.
Second, the method focuses only on earnings. As such, a startup owner might increase the projected revenues. Conversely, venture capitalists aim to lower earnings. It means the method is more of a negotiation game.
Cost-To-Duplicate approach
The cost-to-duplicate valuation approach focuses on the costs and expenses of creating a startup. It aims to determine how much it would cost to build a startup company in Arizona from scratch. Ideally, an investor wouldn’t allow a higher valuation than the sum of all expenses used to create the startup. However, the method does not include intangible assets such as the brand and goodwill.
It means you’ll calculate the physical assets’ fair market value. You can also include patent costs, research and development costs, and others.
One drawback of this method is its failure to capture future company sales. And overlooking intangible assets makes the cost-to-duplicate approach unreliable to many business owners.
Risk factor summation method
It is the perfect fit if you want to use a more generalized valuation method. It provides a base value based on 12 common risk factors. As such, it indicates you have compared your startup to other similar ones, determining if it has a higher or lower risk.
The method uses the following steps:
Begin with an average valuation formulated on similar startups in your region. It might be time-consuming since fetching data from a comparable company can be daunting.
Analyze your startup’s risk factors from the lowest to the highest.
As you’d expect, lower risks will increase your company’s valuation, while higher risks will decrease the company’s value.
To bolster your company’s valuation, work on the risks and develop strategies to reduce risks.
To calculate the value of your business, start with an initial valuation based on either of the above methods, like discounted cash flow. Next, increase or decrease the monetary value in $250,000 multiples based on risks affecting your business.
Ideally, you’ll give a double-plus (++) grade to low-risk and a double-minus (–) to high-risk elements. For example, if your company has a very low competition risk, you will give it a double-plus (++), equating to $500,000.
Political/legislation risk
Unfortunately, the method is more subjective than objective. Therefore, using methods such as discounted cash flow and scorecard may help.
Limitations to startup valuation
Unlike established business valuation in Arizona, evaluating a startup comes with several hiccups. They include:
● Lack of historical data
One chief challenge of startup valuation is the lack of historical financial data. Since the company has been running for a few years, they have a short track record, making it riskier to use predictive methods.
Ideally, startups generate little to no revenue while incurring massive expenses to set up their operations. They tend to have negative cash flows for the first few years.
Generally, starting and running a successful company is no easy feat. In fact, research shows that 50% of startups fail within the first five years. As such, valuation will tend to reflect this high-risk level. The bankruptcy risk correlates to the years the company has been running.
Yet, startups move at different speeds. The pace at which they move from the idea stage, MVP, to a commercialized product is different. Therefore, investors should consider the startup’s growth rate in delivering its services or products.
A startup in Arizona will likely go through the first fundraising stages enabling it to develop a product, go to market, and scale. While rightly so, the valuation process is complicated since the first investors will incur the risk of seeing the value of their shares decrease over time.
Even if a venture is exceptionally successful at increasing its overall value at the exit, the value growth will be lesser for the first investors. Luckily, investors can protect themselves by veto rights or a ratchet.
Do you need a startup business valuation?
As you have seen, valuing your startup allows you to get funding to scale your business. There are different methods, with each having its pros and cons. Besides, it is a complicated process that requires a professional’s input. If you need startup business valuation in Arizona, reach us via our contact channels.
Source - https://wileyfinancialinc.com/why-does-a-startup-need-business-valuation-services/
