Business valuation methods for startups
The business valuation approaches used to value established businesses – income approach, market approach and asset approach – can be applied in startup valuations, but only to some extent. Their application is limited by the fact that startups do not have established revenue streams, assets or much of a history, as long-existing businesses do, and thus a startup valuation process relies heavily on estimates and assumptions. Reviewed below are business valuation methods most commonly used to value startups.
Methods under the income approach
Income approach to business valuation determines the value of a business by converting anticipated future returns of a business into a present single amount. Discounted Cash Flow method, an income-based valuation method which uses discounted future earnings derived from cash flow projections, can produce a quite precise startup business value estimate, assuming the projections it relies on are accurate.
Methods under the market approach
Market approach to business valuation determines the value of a business by comparing the business being valued to similar businesses. Market-based methods, such as Comparative Transaction method, can be applied to valuing startups but the market business prices the startup is compared to should be heavily discounted to reflect the fact that the business concept is yet to be executed.
Methods under the asset approach
Asset approach to business valuation determines the value of a business based on the value of its net assets. As startups do not usually have assets, most asset-based methods are not suitable for startup valuations. The only exception is Cost to Create method – it establishes the business value by determining how much it would cost to build a similar business from scratch.
Rule of Thumb methods
Rule of Thumb valuation methods play a central role in any startup business valuation process. This is because the traditional business valuation methods focus on the financial history of a business – a non-existent attribute for startups, and rely on projections and estimates – an often-unverifiable presumption startups produce, which is prone to overestimation, underestimation, manipulation and bias. To establish a realistic pre-revenue business value estimate, venture capitalists and startup analysts developed a set of rule-of-thumb startup valuation methods – methods which analyse startup quality (Scorecard Valuation method), risk profile (Risk Factor Summation method) and commercialisation activities progress (Berkus method).
By Julia Podgorbunskaya, CPA, Senior Business Valuer at Professional Business Valuers
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