How to Value a Startup for Investing

Startup opportunities are everywhere. Far from the common vision of a tech company with some new string of code, the startup world is filled with sandwich-slingers, cardboard salesmen and trial attorneys looking to get off the ground. And these founders are always looking for money, because the one thing an entrepreneur doesn’t typically have is cash. And while investing in a startup often entails more risk and commitment than other investments, there’s also a bigger opportunity for outsized success.

For help evaluating and facilitating investments, talk to a financial advisor.

Can You Invest in a Startup?

Before getting into valuation, it’s important to touch on the legal parameters surrounding startup investing. When a private company issues formal shares of ownership, this is known as “private stock.” As a general rule, only accredited investors can trade private stock among other investors or on the open market. This means you must have a qualifying attribute – such as net worth of $1 million or more, an income of $200,000 or more, or certain financial licenses. Retail investors have much more limited access to startup opportunities.

What Valuing the Company Means

When we talk about “valuing” a startup, we aren’t talking about the decision to invest. The question is, what you should receive in exchange for your money? Basically, how much equity or ownership should you get per dollar of invested capital?

This is tricky for many reasons, but the core issue is present vs. future value. As PwC notes, startups often initially have negative cash flows, limited financial data and lack a fully developed proof of concept. In other words, their present value is minimal.

But their potential value is high. That’s the whole reason for investing in startups to begin with. If the company’s product or idea succeeds, it can grow significantly beyond its present value, inflating the value of your investment with it.

So when you invest, how much should you receive based on what the company is currently worth vs. what it could be worth? If you invest $100,000 in a company with $50,000 in assets but a potentially million-dollar idea, should you receive the whole firm or a 10% stake?

This is the challenge of “valuing” the investment.

Need help deciding what’s a fair investment? Talk to a financial advisor today.

Assess Based on the Company’s Stage

One method is to start with the stage that the company is at and evaluate the company using a different metric for each stage. You can think about a startup as having five basic stages of development:

Idea/concept – The business does not exist yet and is only an idea and proposal
Seed – The business has just organized and has not yet begun operations
Early Growth – The business has begun operations but is still at proof-of-concept stage
Expansion – The business has begun operating and providing early, growing value
Sustainable Growth – The business is operating with stable cash flows

These five stages of development effectively chart a startup’s progress from pure concept to approaching maturity.

At early stages, such as concept or seed, you will use more objective criteria based on your own comfort level. For example you might offer what’s known as a “fixed range,” basically a set investment you’re willing to offer in exchange for equity (i.e. $100,000 for a 20% stake). This is almost a gamble, and may require setting the terms which you’re willing to bet on this company. Or you might offer to cover the company’s early operating costs in exchange, again, for a fixed equity stake (i.e. 24 months of operating costs in exchange for a 40% stake).

At later stages, once the company has proven its concept and begun operating, you can use criteria based more on the business itself. For example you might use its current rate of growth to project its future growth over the next several years, then value the company based on that. This is known as the “exit-value” approach. Or you might measure its cash flows to try and estimate the company’s long-term value, and invest based on that anticipated value, an approach known as the “discounted cash flow” method.

In all methods, though, the business stage approach has one overall method: Look at the business’ stage of operation, then value it based on where the business falls between potential growth and proven value.

A financial advisor can help you weigh the pros and cons of specific investments.

More Approaches to Startup Valuation

Beyond the corporate stage approach, there are many different analytical methods that investors use to try and value a startup. Pretty much every different firm and investor will have their own approach to this process. However three of the most common are the Berkus Method, the Market Multiple Approach and the Cost-to-Duplicate approach.

The Berkus Method

The Berkus Method, named after the investor who popularized it, is similar to the business stage approach. Here, you analyze a startup according to five separate factors:

Product Idea/Prototype: How good is the business’ product or service?
Core Value of the Business: How sound is the business proposal overall?
Management and Execution: How good is the management team, and so how well does it reduce execution risk?
Strategic Relationships: What relationships does the business have that reduce its market-related risks?
Product Production and Sales: How well is the business positioned to produce and sell its core product?

While the execution is complicated, you generally place a valuation on each factor and invest based on how well the company meets each factor. For example, say you place a value up to $250,000 per factor and someone comes to you with nothing at all except a great idea for a new product. You might invest $250,000, giving them $0 each for core value, execution, relationships and production, but the full $250,000 for product idea.

Remember, a financial advisor can help you determine the best approach to valuation.

Market Multiple

With the market multiple approach you look for similarly-situated businesses and value the startup comparatively. For example, say that someone wants to launch a new productivity app. You might look for other productivity apps that have launched in the same region in the last five years and then estimate the startup’s potential value based on the value those apps achieved.

The advantage to this approach is a sense of certainty. You aren’t inventing numbers, but are rather using market-set values. The disadvantage is that discounts the unique circumstances that make startup investing worthwhile. Ideally the business is different from its peers in essential ways, and measuring it based entirely on those peers can miss that value.

Cost-to-Duplicate

With this approach, you value the business based on what it would cost to start it all over again from scratch. So you add up all of the business’ physical assets, its costs of labor and operation, its research and other development costs, its prototypes and intellectual property, and anything else you would need to spend in order to get back to exactly where the business is now. You use this as the present value of the startup and invest accordingly.

The advantage with cost-to-duplicate is that it gives you a good way of assessing equity value. If it would cost $1 million to rebuild the business from scratch, then a $100,000 investment can give you 10% equity. The disadvantage to this approach is that it ignores all of the intangibles in a business such as market position, goodwill and innovation. It is also an approach that can only really apply to late-stage startups, since you cannot effectively apply cost-to-duplicate to a concept or seed-stage company.

If you still need help, talk to a financial advisor about investing in startups.

Bottom Line

Valuing a startup company for investment is a tricky process. The core value to a startup is its potential, an unproven but potentially high-value asset. Multiple approaches exist to try to value startups.

Tip

A financial advisor can help you build a comprehensive investment plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.