How To Calculate Your Startup’s Valuation

According to Pitchbook, almost 70% of startup investments fall short of their first valuation — highlighting the need for realistic expectations. After all, misaligned startup valuations can cost founders critical funding opportunities. So, what’s the way forward?

You can calculate your company’s worth by using the Market Multiples Approach, Discount Cash Flow Method, or the Venture Capital (VC) Method. The “right” valuation method depends on your startup’s growth stage. 

However, knowing your startup’s valuation will help to determine its fair market value (FMV) — even if you have little operating history. In this article, we will explore the three valuation methods we mentioned earlier and show you how you can use them to supercharge early funding decisions.

1. Market multiples approach

The Market Multiples Approach method uses data already obtained from similar companies valued by the market before through public acquisitions or offerings. This method compares the financial metrics of your startup (like your revenue and user base) to those of companies similar to yours and applies the exact multiples (such as price-to-sales ratio) to get an estimate of your startup’s value.

For example, when a publicly traded company in an industry similar to yours, with equally similar revenue and growth potential, has a price-to-sales ratio of 20. Your startup has an annual income of, say, ₦100 million — the market multiples approach will suggest a valuation of ₦2 billion (20 * ₦100 million). 

To understand the market multiple approach, we have listed some key metrics you should take note of:

1. Price-to-Sales (P/S) Ratio: Market value / Annual revenue 
2. Enterprise Value (EV)/Sales Ratio: Enterprise Value / Annual Revenue. The Enterprise value is considered all the cash and debt a company has.
3. Price-to-Book (P/B) Ratio: Market value / Book value per share. The book value shows a company’s net assets and is usually less relevant for startups.
4. Price-to-Earnings (P/E) Ratio: Market value / Earnings per Share. This is less applicable for startups at an early stage since they possibly have limited profits.

The sample table below lets you get a feel of variations across industries:

Industry	Price-to-sales (P/S) ratio
Software/technology	15-20
Consumer goods	5-10
Healthcare	10-15
Financial services	2-5

Therefore, to accurately use this valuation method, you must find comparable companies to get an accurate valuation.

How to use the market multiples approach

Here are some tips for using the market multiples approach to value your business:

1. Focus on companies in your line of business or at least closely related to your field.
2. Look for companies at a similar stage of development to your startup, be it an early stage or a growth stage.
3. Compare key metrics, like revenue, profitability, and user base, to make sure they’re a good fit.
4. Consider the target market and growth potential for both your startup company and the company you are comparing with.

If you’re unsure where to search for companies that can be compared to yours, look through financial news sources, public data, or industry reports.

Limitations of the market multiples approach

While this approach is practical, it has its challenges, particularly for early-stage startups:

• Lack of comparable data: Early-stage startups often lack robust financial metrics, making it hard to find comparable companies.
• Market volatility: Multiples may be inflated or depressed based on industry trends or market conditions, leading to unrealistic valuations.
• Unfit metrics: Certain ratios, like Price-to-Earnings (P/E), may not apply to startups without profits.

Therefore, if your startup is in its infancy or operates in a niche market, consider complementing this method with others (like the Venture Capital Method) for a more balanced valuation.

2. Discounted cash flow (DCF) method

The Discounted Cash Flow (DCF) method focuses more on the future potential of your startup. It simply forecasts your startup’s future cash flows over a specified period and then returns that cash flow to its present value. The discounted rate then shows the risk associated with the startup and the time value of money.

The core formula for DCF is:

Present Value = Future Cash Flow / (1 + Discount Rate)^n

Where:

• Future Cash Flow is the projected cash inflow for a given year.
• Discount Rate represents the risk or cost of capital.
• n is the number of years into the future for the cash flow.

For instance, if you anticipate ₦50 million in cash flow five years from now, with a discount rate of 10%, the present value of that cash flow would be:
₦50 million / (1 + 0.10)^5 = ₦31.06 million

How to apply the DCF method for startup valuation

Here’s how to use the DCF method to value your startup:

1. Project free cash flow to the firm (FCFF): Forecast your startup’s cash flows after accounting for all operating expenses, taxes, and capital investments over a specific period (e.g., 5 to 10 years).
2. Choose a terminal value: Estimate the value of your startup at the end of the forecasting period, using industry benchmarks or a perpetual growth rate.
3. Apply the discount rate: Calculate the present value of each year’s projected cash flow and terminal value using a discount rate that reflects your startup’s risk and cost of capital.
4. Calculate the enterprise value: Sum the discounted cash flows to determine your startup’s total present value.
5. Determine equity value: Subtract total debt from the enterprise value to calculate the equity value of your startup.

Challenges of using the DCF method

Here are some challenges you might encounter when using the DCF method:

• Accuracy of cash flow projections: For early-stage startups, forecasting cash flows can be challenging due to a lack of operating history and unpredictable market conditions.
• Choosing the right discount rate: Determining an appropriate discount rate requires considering the inherent risks of your business and industry.
• Uncertainty in terminal value: Estimating your startup’s worth at the end of the forecast period can be speculative, especially in volatile markets.

While the DCF method offers a structured approach to valuation, it is most suitable for startups with relatively stable financial data or those at a growth stage. For early-stage startups with limited financial history, combining this method with others like the Market Multiples Approach can provide a more balanced valuation.

3. Venture capital method

The Venture Capital Method takes the perspective of a venture capitalist who invests in startups with a high expectancy of significant returns. This method considers the Return On Investment (ROI) for venture capitalists and factors in the potential of exit strategies (like acquisition) to arrive at a pre-investment valuation for your startup.

Since venture capitalists aim for high ROI and plan to exit within a specific timeframe, this method incorporates the desired ROI to determine how much equity is needed.

Here’s the simplified formula used in the VC method:

Post-Money Valuation = Terminal Value / (1 + Desired ROI)

Pre-Money Valuation = Post-Money Valuation – Investment Amount

Post-money valuation represents the value of your startup after the VC investment, while pre-money valuation represents the value of your startup before the VC investment.

Let’s say a venture capitalist expects a terminal value of $50 million and a desired ROI of 10x.

Using the formula above:

• The post-money valuation is $50 million / (1 + 10) = $50 million / 11 ≈ $4.55 million

If the VC plans to invest $1 million, the Pre-Money Valuation would be:

• Pre-Money Valuation = $4.55 million – $1 million = $3.55 million

This means your startup is valued at $3.55 million before the investment and $4.55 million after the investment.

How to choose the right startup valuation method

It could get confusing when it comes to choosing what valuation method fits your startup.

Well, choosing the proper technique to value your startup depends on several key factors:

1. Stage of development: For early-stage startups that most likely have a limited amount of financial data, the Market Multiples Approach or the Venture Capital Method may be the best options for you. They rely more on industry standards and future potential.. For growth-stage startups with more concrete financial data, the Discounted Cash Flow Method will be more beneficial and comprehensive.
2. Availability of financial data: The DCF method is heavy on accurate financial forecasts, and this might be pretty challenging for early-stage startups. If the revenue and profit data are scarce or limited, it is best to consider the MM approach and the VC method since they place less emphasis on financial data.
3. Potential of future growth: If your startup is relying on future growth and potential, the VC and DCF methods are more of an advantage to you since both of these methods consider the terminal value more. 
4. Investor expectations: if you’re more interested in securing funding from venture capitalists, getting the hang of the VC method will be essential for negotiations. However, the other methods, like the MM approach, can be of value when comparing and establishing a baseline valuation. 

The best approach for your startup valuation often involves a combination of methods by taking equal averages based on the factors listed above. However, you’d be better off consulting a financial professional to help you choose the best valuation method for your business.

Factors that can affect startup valuation

The valuation methods for your startup provide the overall framework. However, other factors can influence the total value of your startup.

Some factors that affect your startup’s valuation include:

1. The market size and the future potential. Investors will be more likely to tilt towards startups with a clear path than one with a sizable “future” market.
2. The quality of your team. The strength of the management team is a key factor if they are seasoned and experienced. The track record of your management team gives off a bold face to investors who are suckers for a strong team that can execute the business plan despite whatever challenges might be faced. 
3. Intellectual property. Owning properties like patents, trademarks, or technology can provide a significant competitive edge and translate to a higher valuation for your startup.
4. Economic conditions. Overall economic conditions can have an impact on your startup valuation. When there is a downturn in the economy, the risk the investor can take decreases, potentially leading to a lower valuation during downturns and higher valuations in periods of economic growth.

Conclusion

Knowing your company’s worth is essential when making business decisions. The methods we have discussed in this article can serve as a guide to helping you estimate your startup’s value. However, when dealing with more complex valuations, we advise you to seek professional guidance for a more accurate value assessment. 

At Ingressive Capital, we combine proven valuation methods with deep market expertise to help startups unlock their true potential. Our extensive network and resources position founders for success.

So, visit our founder application page and take the first step toward accelerating your growth!