Cracking the Code: A short Guide to Valuating Startups for Savvy Investors, Including how was for Instagram

Navigating the Startup Valuation Maze — Unraveling Key Metrics, Strategies, and Pitfalls for Informed Investment Decisions

The first time I went to a startup pitch competition a journalist approached me and ask me for the first time of my life “how much is your startup valuated?” I had a rudimental pitch deck but not prepared to this simple straightforward question, which apparently summarizes a lot. In this article I summarize a bit what this means, I give a brief introduction to common metrics, and consider an hypothetical example plus how it was for Instagram.

Valuing a startup is a crucial aspect for young entrepreneurs hoping to raise capital for their startup, you need to know how much your are worth overall. To reach this conclusion many important elements that must be taken into account in order to calculate its value. These variables include the startup’s industry, the size of the market, the possibility for future revenue, the company’s moat, and the team’s level of experience (investors will talk to you to see who you are, not just due diligence on paper).

First of all, the valuation of a business is heavily influenced by the industry in which it operates. Investors find different industries interesting for different reasons, based on things like market trends, potential for growth, and general demand. A startup that operates in a rapidly expanding area, such as artificial intelligence or renewable energy, can command a greater valuation because of the possibility of significant returns on investment. Then, the target audience’s market size is another important consideration for the firm. A small specialized market business may have less room for growth and, as a result, a lesser valuation. However, investors are more inclined to view a firm that serves a sizable and expanding market as having strong growth prospects, which raises the startup’s valuation.

Lastly, revenue growth potential is a vital factor in valuating a startup. Investors are interested in startups that demonstrate consistent revenue growth or possess a clear path to profitability. Startups with a proven revenue generation model and a solid strategy to scale their operations are more likely to be valued higher as they offer a higher probability for returns on investment.

Gathering information

In order to obtain pertinent financial data on a recently established firm, we must concentrate on essential elements including earnings, costs, assets, and liabilities.

1. Revenue: To begin, look at the startup’s sources of income. This covers all revenue received from services, sales, and other sources. Seek invoices, transaction histories, or sales records to find out how much money the business made overall over a given time frame. You might need to anticipate possible revenue based on sales projections or market research if your startup is just getting started.

2. Costs: Determine and gather data regarding the startup’s costs. These can include any expenses linked to running the firm, such as rent, utilities, marketing costs, salaries, and operational costs. Examine invoices, financial accounts, and receipts to create a clearer understanding of the financial situation.

3. Assets: List all of the startup’s possessions, including its assets. This covers both actual assets like machinery, supplies, and real estate as well as intangible assets like trademarks and patents. Make a list of all the startup’s assets and give them a fair market value or, if one is available, an expert appraisal.

4. Debts: Determine the startup’s liabilities, or the debts or commitments owed by the business. This can include any kind of debt, unpaid invoices to vendors or suppliers, or other financial commitments. In order to create a list of the startup’s liabilities, including the amounts owing and their due dates, review contracts, loan agreements, and financial records.

Once we have all these information, we can put them together with appropriate methods.

Choose the right valuation method

There are several valuation methods that can be used to estimate the value of a startup. The most common methods include: 1. Discounted Cash Flow (DCF) Method: This method involves estimating the future cash flows the startup is expected to generate and then discounting those cash flows to their present value using an appropriate discount rate. The DCF method takes into account the time value of money and provides a valuation based on the projected profitability of the startup. For example, let’s consider a hypothetical startup with projected cash flows of $100,000 per year for the next five years. Using a discount rate of 10%, we can calculate the present value of each cash flow and sum them up to get the startup’s valuation.

2. Market Multiple Method: The market multiple method , also known as the price-to-earnings (P/E) ratio, compares the startup’s financial metrics with similar companies in the industry that have been recently acquired or have gone public. Common metrics used in this method are revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), or user base. By analyzing the multiples (e.g., revenue multiple of 3x), we can determine the valuation of the startup. For instance, if a comparable company with similar revenue was recently acquired for $10 million, and our startup has $2 million in revenue, we can estimate the valuation to be around $6 million (3x revenue multiple).

3. Scorecard Method: The scorecard method involves assessing various factors related to the startup’s team, market size, intellectual property, and competitive advantage. Each factor is assigned a weight based on its importance, and a score is given to the startup for each factor. These scores are then multiplied by the respective weights and summed up to calculate a numeric score. This score is then compared to a benchmark to determine the startup’s valuation. For example, if our startup receives a score of 80 out of 100 and the benchmark valuation for similar startups is $5 million, we can estimate our startup’s valuation to be $4 million (80% of $5 million).

It is crucial to remember that every valuation technique has advantages and disadvantages of its own. Entrepreneurs have the option to select one or a mix of these strategies based on the features of their firm and the tastes of possible investors.

Hypothetical example

Let’s create a hypothetical startup called “WallaWalla” which is a software development company. WallaWalla has been in operation for 3 years and has experienced steady growth. Here is some relevant financial data :

• Year 1 Revenue: $500,000
• Year 2 Revenue: $1,000,000
• Year 3 Revenue: $1,500,000
• Year 1 Expenses: $200,000
• Year 2 Expenses: $300,000
• Year 3 Expenses: $400,000
• Year 1 Profit: $300,000
• Year 2 Profit: $700,000
• Year 3 Profit: $1,100,000

Let’s assume we choose the Earnings Multiple approach for valuation. This approach values the startup based on its earnings times its Multiple, the formula is:

Valuation = Earnings x Multiple

The multiple can vary depending on various factors such as the industry, growth potential, market conditions, and risk factors. In practice a measure of how much investors are willing to pay for each dollar of earnings generated by the company. For our hypothetical example, let’s assume a multiple of 5 for Wallawalla.

Instagram as real example

Instagram is a well-known social media site where users share mostly images and videos. Mike Krieger and Kevin Systrom created it, and it was released in October 2010. Instagram attracted a sizable user base very fast and became extremely successful in its early phases. They were purchased for about $1 billion in 2012, paid for with stock and cash. A number of reasons went into Instagram’s $1 billion value. The quick expansion and engagement of Instagram’s user base was one important factor. With over 30 million registered users and an estimated 5 million daily active users at the time of the acquisition.

Already in those days, people were well aware of the concept of network effect. Indeed the number of registered users was attractive.

Although Instagram was not generating significant revenue at the time of the acquisition, investors recognized its potential for monetization through advertising and sponsored content. I doubt in those days Facebook (now Meta) was aware how addictive the app was, but also they took into consideration it was very similar to their original social media, if not more fluid.

Furthermore, the acquisition of Instagram by Facebook provided strategic synergies, which further increased its valuation. By integrating Instagram’s features and user base with Facebook’s existing platform, Facebook could enhance its overall user experience and advertising capabilities.

I hope this brief introduction is giving you an idea how much your startup can be valued, so you are prepared where you stand and what to reply if asked.

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