4 Common Valuation Models - An introduction

Business valuation as it relates to crowdfunding is a mixture of science and dark art. Elsewhere we’ve talked about the approach to business valuation in general, but in this article, we’ll discuss 4 of the more common valuation models typically used by VCs and other institutional investors, and sometimes Angels, for startup and early-stage businesses. 

I should stress that we’re not company valuation specialists and nor is it our role to suggest which valuation model is the best for any given circumstance. However, it’s useful to have a basic understanding of the more formal methodologies, so the purpose of this article is simply introduction and awareness; please don’t take it as actual training!

It is important to appreciate that there is no single widely-accepted model for how to value startups. As well as there being a lot of subjectivity involved along with a wide range of variables, VCs etc have an array of different investment motivations and strategies which can have a significant impact on how a valuation is arrived at. 

So take a seat, in no particular order, here are the 4 more common methodologies, described in very basic terms:

Dave Berkus Valuation Method

Dave Berkus is a well-known author, lecturer, and serial angel investor. It’s fair to say that he’s been there, done that, and bought the T-Shirt. And he probably sold the T at a significant profit too. He’s a legend. 

The core premise of this model is that the pre-money valuation of the business starts at zero. The model then considers five factors, each of which is assessed and then assigned a value of between zero and £400k, with all the factors then added together. Therefore in theory, at least the maximum pre-money valuation possible is £2M although some people do set a higher threshold for each of the factors. In any event, all factors must be of equal priority and value. 

The factors which this model uses are:

• Soundness of idea
• Quality of management team
• Quality of governance/advisory team/board
• Existing of a working prototype or proof of service concept
• Status of rollout out/sales/revenue

Scorecard Valuation Method

The SVM is similar to the Berkus approach in that it also assesses broadly similar factors, adding in more detail around market dynamics such as size, route, and competition. The SVM also then compares these factors against other funded businesses. 

This model starts by first identifying the valuation for a group of recently funded businesses, in the same sector and at a similar stage, to arrive at an average pre-money valuation for the group. This is then the benchmark valuation to assess the target company against.

In very simple terms, a scorecard developed from each of the assessment factors is then used to compare the target business alongside a number of similar funded businesses based on your perception of the relative strength or weakness of those businesses against the target. 

One of the differences of this model against the Berkus model is that SVM allows different weightings of importance for each of the assessment factors. For example, you might determine that the strength of the founding team is more important than any other factor, and you might likewise determine that market competition warrants only minimal importance. 

This model sounds a bit complex because it is, but fortunately, there are a number of online calculators that do the job for you. Here’s one such example as provided by Seedrs: Seedrs Startup Valuation Calculator.

The Risk Factor Summation Method

Another more broad model, this one works on the basis of identifying the key risks which apply to the target business. One of the most obvious risks is management. Other typical examples include competition, supply chain, and environmental along with many more. 

Each of the identified risks is then assessed as follows: 

Starting with an average pre-money valuation as reached in a similar way as described for the previous model (SVM) the valuation for the target company is adjusted upwards by £200k for +1 positive, £400k for +2 positive, nil for neutral, and downwards for -1 and -2 i.e. -£200k for -1 and -£400k for -2.

So let’s say you identified an average pre-money valuation for recently funded businesses in your sector and stage of £3M. You might assess your target company as follows:

This - somewhat simplistic - example shows that your target company valuation would be £200k higher than the average of £3M, therefore £3.2M.

Venture Capital Valuation Method

This model was developed by the Harvard Business School in the late 1980s. 

In theory, at least, it’s a relatively simple model based on first establishing a post-money valuation and then arriving at a pre-money valuation by the application of simple arithmetic. 

The venture capital valuation methodology is based on the following calculations and assumptions:

Return on Investment (ROI) = exit value divided by post-money valuation;

Post-money valuation = exit value divided by anticipated ROI multiple.

 Exit value is the anticipated selling price for the company at some future time. The selling price can be estimated by forecasting revenue for the year of sale and, based on that forecast, estimating earnings in the year of the sale.

For example, a business with revenue of £20,000,000 upon exit might expect to have post-tax earnings of 15% or £3,000,000. Using known industry-specific price-to-earnings (PE) ratios, a say 15x PE ratio for the business would give an estimated exit value of £45m.

For the purpose of this example, let’s anticipate an ROI of 25x. (Actual realised exit multiples might vary, depending on the sector, between say 7x and 40x)

Assuming the business needs £500,000 to achieve its strategic objectives, the pre-money valuation is calculated as follows:

Post-money valuation = Exit value divided by ROI multiple. 

Therefore in this example: £45m / 25x = £1.8m

Pre-money valuation = Post-money-valuation less investment sought.

Therefore in this example: £1.8m – £500,000 = £1.3m pre-money valuation.

Summary (phew…)

• Despite the varying levels of complexity, there’s no one model better than any of the others. 
• They’re all based on qualitative and speculative assessments, judgements and assumptions, and few if any verifiable facts.
• The application for these types of models is for startup and other early-stage businesses; they’re not used for valuing later-stage, mature, or publicly-listed companies.
• At the end of the day, the value of your business is what someone will pay for it. 
• For further reading, here’s a link to our article, 9 one-liners about Business Valuation.

I think I’ll have a lie down now. 

Author: Richard Mojel, Commercial Director, ISQ