How To Value Early-Age Startups

India is often touted as one of the biggest startup ecosystems worldwide. As of 31st December 2023, DPIIT recognised 1,17,254 startups¹ in the country. This also creates a great investment opportunity for those who are willing to put their money into these young startups.

Evaluating a late-stage startup is a little easier as you have access to the historical performance of the company. However, valuing an early-age startup can be complicated. Let’s understand the meaning of start-up valuation, why it is challenging to calculate, why it matters, various valuation methods, and everything else you need to know about it.

What Is Startup Evaluation

Whenever a startup is established, it usually tries to raise funds for establishing operations and for business growth. But how much should you invest in these companies, and what equity should you ask for in the investment? It is something that's decided based on startup valuations.

Put simply, start-up valuation refers to evaluating the worth of a venture. It can be calculated based on the core idea or product of the business, founders, minimum viable product, initial sales, and other factors.

Valuation, by its very nature, depends on the judgement of professionals about what a business is worth. Making these judgements becomes even more complicated for early-stage startups where there is no data to back the value.

While discussing startup valuations, it is important to get familiar with the terms pre-money valuation and post-money valuation. As the terms give out, pre-money valuation is the valuation of the company before it receives any funding. On the other hand, post-money valuation is the venture's worth after the funding. In mathematical terms

Post Money Valuation = Pre Money Valuation + Funding Raised

Consider the image below, where the first pie chart shows a pre-money valuation. Suppose the startup is valued at INR 1 crore (this is the pre-money valuation); the investor invests INR 25 lakhs. Hence after the first investment, the post-money valuation is INR 1.25 crores. Since the investor invested INR 25 lakhs, the equity stake of the investor is 25/125 or 20%. 

Why Valuation Matters For Early-Age Startups

Evaluation of a company’s net worth is very important for startup investment purposes. As explained above, the equity that an investor gets for a particular amount is directly influenced by the company's valuation.

In 2023 early-age startups raised $2.5 billion² through 656 deals. One of the early-stage startups that raised funding recently in January 2024 is Grip Invest. The investment platform received funding of $10 million³ ($1.5 million in debt and $8.5 million in equity) in a round led by Stride Ventures.

Besides influencing investments, valuation also plays a significant role as a key indicator of a startup's financial health over time. Thus, determining an appropriate amount at the very start is of utmost importance.

Also Read: Understanding Startup Equity: A Beginner's Guide To Investing In Early-Stage Companies 

Common Valuation Methods For Early-Age Startups

There are multiple startup valuation methods to evaluate an early-stage startup; here are some of the most common ones:

1. Cost-to-Duplicate

The cost-to-duplicate method is basically calculating how much it would cost to build an exact duplicate company from scratch. The idea behind this method is to value a venture based on its physical and digital assets.

For example, suppose there's a fleet management company that wants to raise funds. This method would simply add the costs of the vehicles owned by the business, any software built for fleet management, etc., to calculate its current value.

The drawback of this method is that it only considers quantifiable assets and not the potential of the startup. For instance, if the fleet rental company had found a huge gap in the market and had an idea to fill it and generate substantial revenue, it would still be valued based only on quantifiable assets.

2. Market Multiple

Another of the popular startup valuation methods is market multiple. Put simply, the investors make a startup investment through this method by looking at recent acquisitions of similar companies and evaluating accordingly. However, there are many other characteristics that can be considered in this method, such as:

• The age of the startup
• Sales data
• Number of customers acquired over time, etc.

This method can give you close estimates of what the company’s net worth is. There is, however, one major problem with this method. It assumes that the company being valued is similar to other companies that were used as reference points.

3. The Berkus Method

The Berkus Method is based on the idea of the venture capitalist Dave Berkus. It primarily focuses on valuing pre-revenue startups. These are the startups that haven't yet generated any revenue from the customers. The core of the method revolves around five key metrics considered to be the basic foundation of any startup.

The five key metrics considered here are:

• Idea
• Prototype
• Management team
• Strategic relationships
• Sales

Based on the quality and efficiency of these indicators, a certain amount is assigned to each one of these key metrics and is then clubbed to calculate the final valuation. However, it has limited scope because it does not consider many other market factors that can influence the valuation amount.

4. Discounted Cash Flow

Discounted Cash Flow (DCF) can be one of the best startup valuation methods for early-age ventures because it relies on the future potential of a company. It forecasts how much revenue or cash flow the company as a brand or the basic idea behind it can generate. A discounted rate is applied to the cash flow because of the high risks involved with early-stage startups.

The discounted amount is justified from the investor's point of view; after all, they are taking a huge risk by investing in an early-age startup. An IBM study⁴ found that as many as 90% of startups fail within the first five years. The only problem with this method is that without any historical data, projecting sales and revenue becomes extremely challenging.

Factors Influencing Early-Age Startup Evaluation

Valuations don't just happen based on intuitions and judgements. If that were the case, founders would value their ventures to be worth crores and crores of rupees. There are certain factors based on which the early-age start-up valuation is determined:

• Revenue: Whether the startup is pre or post-revenue can have a significant influence. If it is post-revenue, how much the company has already generated can be considered.
• Growth Potential: Based on the foundational idea, product, or service of the business, future growth is estimated to find startup valuations.
• Market Size: Demand for any particular physical or digital product offered by the startup can help project the sales potential and, thus, the valuation.
• Management Team: A company that has a strong and reliable management team is more likely to show growth in the future. Therefore, investors should consider the management team to be one of the most significant factors influencing early-age evaluation.
• Competition: The startup's valuation may be impacted by the degree of industry competition. A startup in a highly competitive market might be worth less than one in a less crowded one. High competition can make it tough for a business to achieve market share, which might limit its revenue and growth potential.

Conclusion

Early-age startup valuations are the foundation for making critical decisions for investors. It gives them a baseline idea about the current and potential growth of a startup. You can use various methods to evaluate a startup and invest accordingly. With the right valuation idea, you will be able to identify the right startups to invest in. Once you find an opportunity, you will need a medium to make investments. You can rely on Grip Invest for curated investment opportunities that go beyond stocks, fixed deposits, and gold to make seamless investments.

Frequently Asked Questions On Early Stage Startup

1. What is the rule of 40 for early-stage startups?

By integrating the growth rate and profit margin, the rule of 40 is a measure that may be used to assess the health of a firm. A combined score of 40 or higher indicates strong financial performance for the startup.

2. What is the lifespan of a startup?

While a startup's life expectancy varies greatly, many fail in the first few years. With the right management and adaptation, successful startups can develop into well-established companies that last a lifetime.

References:

1. Ministry of Commerce & Industry <https://tinyurl.com/bdxxe6h6>

2. Entrackr <https://tinyurl.com/46chah7e>

3. The Economic Times <https://tinyurl.com/58w8xnp2>

4. IBM <https://tinyurl.com/54tw39pm>

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