Startup valuations provide insight into a company’s ability to use new capital to grow, meet customer and investor expectations, and hit the next milestone. Today, unicorn valuations — businesses valued at $1 billion or more — are in the hundreds. There are now “decacorns,” startups valued at $10 billion, and even “hectocorns,” valued at over $100 billion ¹.

However, entrepreneurs often concentrate too much on valuation. They should be looking at the deal as a whole — What value-add will you receive from the VC? Will the VC micro-manage the company? What are the economics of an exit? It is all very well negotiating a fantastic valuation, but it will make no difference if you have ceded all of the economics and control in the process ².

Startups are notoriously hard to value accurately since they do not yet have operating income or perhaps even a salable product and will be spending money to get things going ³.

The Valuation Puzzle: Pre-Money vs. Post-Money

Understanding your company's valuation is crucial in the world of startups and venture capital. But not just any valuation - they can be of two types - Pre-Money or Post-Money.

Understanding the difference between pre-money and post-money valuation is crucial for any entrepreneur seeking investment. It's like dissecting the layers of an onion; each peel reveals a deeper truth about your company's worth.

Pre-Money: Your Company's Worth Before Investment

Imagine your company as a bakery bustling with activity but still baking its name in the industry. The pre-money valuation is like the bakery's worth before a famous food critic walks in – its equipment, ingredients, and potential, untapped by external investment.

  • Fully diluted basis: We factor in all potential future shares, like icing sugar sprinkled over the valuation, including convertible securities (think special ingredients) and employee options (rising dough!).

The Option Pool Trick: Dilution's Disguise

Entrepreneurs should look very carefully at the effect of the option pool on the pre-money valuation. As part of the investment, it is fairly common for an option pool to be either established or the number of shares available under the option pool to be increased. It is important to agree that the establishment or increase of the option pool will occur pre- or post-investment. If the option pool is to be established/increased pre-investment, the pre-money valuation of the company is effectively reduced which will result in further dilution to the shareholders (sometimes referred to as the option pool shuffle)*. 

Example: The Hoppy Toad Brewery receives a $3 million offer from Sudsy Investors on a $15 million pre-money valuation, but Sudsy wants a 10% option pool before they crack open a deal.

  • The effective pre-money becomes $13.5 million ($15 million - $1.5 million option pool).
  • The true cost? It's not just the $3 million investment; the brewery's value shrinks, diluting everyone's pint.

Therefore, in our personal opinion, the entrepreneurs have two options:

  • Post-investment option pool: Everyone shares the dilution later, like waiting for the whole cake to be baked before dividing it.
  • Partial pre-investment pool: Only bake enough extra flour initially, leaving room for adjustments if needed later. You can also provide other anti-dilution measures to the investor to protect their interests. 

Post-Money: Your Company's Worth After Investment

The post-money valuation tells you what your company is worth after receiving an investment. It's like the price tag on your business after a cash injection.

Example: Bloomfield Biosciences is attracting some serious interest from Thrive Capital. Thrive wants to inject $5 million for a 20% stake in Bloomfield. Here's how the two types of valuation would be calculated:

  • Post-money valuation: $25 million ((5 million / 20) * 100)
  • Pre-money valuation: $20 million (Post-money valuation ($25M) - Investment ($5M))

Remember, the pre-money valuation reflects your company's value before the investment. So, with that fresh $5 million from Thrive, Bloomfield instantly jumps from a $20 million to a $25 million valuation.

Why It Matters:

  • Clarity for Everyone: A clear post-money valuation ensures everyone – founders, investors, lawyers – knows exactly how much the company is worth after the deal. No room for confusion or hidden agendas.
  • Term Sheet Essentials: Always, always, always make sure your term sheet includes a capitalization table. This table shows the ownership breakdown of the company before and after the investment, including any existing shareholder stakes and potentially new option pools for employees. It's your roadmap for clear sailing.

Why is it so Hard to Value Startups?  

Valuing a startup is both an art and a science. While valuations are necessary, there are several hurdles to overcome when assessing how much a start-up company is worth. These challenges may include but aren’t limited to the following:

  1. Lack of Historical Financial Information: Start-ups frequently lack financial historical information, making it difficult to evaluate their performance, revenue creation, and potential profitability. Traditional valuation techniques may be less useful as a result of this data shortage.
  2. Dependence on Future Performance: Because startups operate in rapidly changing marketplaces, it is challenging to predict their future growth.
  3. Lack of Comparables: Startups frequently propose ground-breaking technologies or unique business strategies, which usually don’t have established alternative standards or comparables. For this reason, It is challenging to locate comparable businesses for valuation. It is also quite common in our experience that the comparables may have only raised capital by issuing securities to private individuals, and as a result, those securities are not listed on public exchanges.
  4. Uncertainty in Funding Rounds: To support their expansion, start-ups often depend on several funding rounds. Based on investor opinion, market conditions, and the company’s development, valuations may change between various funding rounds, complicating the valuation process.
  5. Subjectivity and Biases: Because it mainly relies on presumptions, market trends, and investor opinions, valuing start-ups entails some subjectivity. Divergent valuations may result from different investors’ varied risk tolerance levels and growth forecasts.

To overcome these challenges, investors and stakeholders should use a combination of valuation methods, including discounted cash flow analysis, cost-to-duplicate, and stage valuation. Understanding the different startup valuation methods can help you determine the company’s worth and prospective return on investment. Valuations are crucial to fundraising operations, as they decide the amount of money to be raised and the ownership stake to be offered to investors. They also support strategic planning, goal-setting, and internal decision-making for budgeting, resource, and capital allocation.

7 Most Popular Startup Valuation Methods

Let’s discuss the most exciting part of this article - various methods of valuing a startup. But before we dive in, let me share some insights I’ve gained over the past decade. Calculating the value of a startup is not an exact science and involves a bit of guesswork. While financial statements like balance sheets are essential, your network, skills, experience, and personality also play a significant role in determining the value of your startup. It’s critical to assess the strengths and weaknesses of the founding team, especially in the initial years, to get a more accurate valuation.

It’s also important to note that valuations will differ across locations, industries, and years. For instance, a Silicon Valley AI startup founded in 2012 shouldn’t be the benchmark for an Indian AI startup in 2023. Similarly, a B2B company may have dramatically different inputs than a B2C company. So, it’s crucial to consider these factors when valuing your startup.

Now let’s dive into the seven most popular methods of startup valuation: 

1. The Berkus Method.

American venture capitalist and angel investor Dave Berkus created the Berkus approach. It’s a great way to assess the value of a startup. The method looks at five critical success factors: 

  • Basic value, 
  • Technology, 
  • Execution, 
  • Strategic relationships in the core market, and 
  • Production and consequent sales. 

Under this method, a detailed assessment is carried out to evaluate how much monetary value is assigned to each of the factors mentioned above. The startup’s value is the total sum of all economic values assigned to each factor. This approach typically allocates up to $500,000 per success factor for a theoretical maximum pre-money valuation of $2.5 million. The Berkus approach may also be referred to as the stage development method or the development stage valuation approach.

2. Market Multiple Approach

Under this method, the startup’s value is decided using a market multiple using recent acquisitions or transactions similar to the startup. The startup is then valued using the calculated market multiple. For instance, let’s say Acme Corporation, a fictional startup, was acquired for $54 million. Its mobile app and website had 120,000 users, translating to roughly $450 per user. If your startup is in a similar field and has 76,000 users, then your business would be valued at around $34.2 million.

3. Scorecard Valuation Method

This method is another option for pre-revenue businesses. It works by comparing your startup to others that are already funded but with added criteria. First, you find the average pre-money valuation of comparable companies. Then, you consider how your business stacks up according to the following qualities:

  • Strength of the team: 0-30%
  • Size of the opportunity: 0-25%
  • Product or service: 0-15%
  • Competitive environment: 0-10%
  • Marketing, sales channels, and partnerships: 0-10%
  • Need for additional investment: 0-5%
  • Other: 0-5%

You’ll then assign each quality a comparison percentage. Essentially, you can be on par (100%), below average (<100%), or above average (>100%) for each quality compared to your competitors. For example, suppose you give your e-commerce team a 120% score because it’s fully trained and has experienced developers and marketers, some from rival businesses. In that case, you’d multiply 30% by 120% to get a factor of .36. Do this for each startup quality and find the sum of all factors. Finally, multiply that sum by the average valuation in your business sector to get your pre-revenue valuation. You can learn exactly how to assign percentages and weigh each factor in this explanation by Bill Payne, the method’s creator.

4. Cost-to-duplicate 

The key to this method is in the name. You’re figuring out how much it would cost to recreate your startup elsewhere — minus any intangible assets, like your brand or goodwill. 

You simply add up the fair market value of your physical assets. You may also include research and development, product prototypes, patents, and more costs.

One major drawback is that this method inherently doesn’t capture the total value of a company, particularly if it’s generating revenue. In calculating your startup’s valuation, you may have to ignore particularly relevant elements, like your customer engagement. 

5. Discounted Cash Flow 

The discounted cash flow (DCF) method projects the startup’s future free cash flow. A rate of return on investment, the discount rate, is then estimated. Since startups are new companies with a high risk associated with investing in them, a high discount rate is generally applied. The future free cash flows are then discounted back to the present value.

You can also consider the First Chicago Method, which expands on the DCF method. It considers three scenarios — the other two being one in which the startup performs poorly, according to projections, and one in which it performs even better than expected — giving you three different business valuations. 

6. Risk Factor Summation Method

Imagine your valuation as a sturdy ship sailing toward success. The RFS method equips you with a detailed map, plotting smooth seas and hidden reefs – your business's inherent risks. Then, increase or decrease that monetary value in multiples of $250,000 based on risks affecting your company. 

Establishing a Baseline: Every journey needs a starting point. Before factoring in risks, set a baseline valuation with methods like the Scorecard or Comparable Transactions. These provide a solid foundation for the RFS to build upon.

Risk Adjustments: Now, adjust your valuation based on identified risks, akin to assigning grades:

  • Double Plus (++): Low-risk elements like a skilled team or a booming market deserve a celebratory boost.
  • Plus (+): Moderate risks, like minor competition, warrant a cautious increase.
  • Minus (-): High-risk factors, like shaky legal ground, demand a course correction, subtracting from your value.

Navigating Rough Waters: The 12 key risk categories act as your compass, covering areas like management, funding, and technology. Group them into themes like "operational," "market," and "financial" for a more straightforward assessment. Remember, objectivity is vital. Benchmark your risks against industry standards, analyze competitor strategies, and seek expert opinions to avoid sailing off course. By the way, the 12 common risk categories are as follows: 

  1. Management
  2. Stage of the business
  3. Legislation/political risk
  4. Manufacturing risk
  5. Sales and marketing risk
  6. Funding/capital raising risk
  7. Competition risk
  8. Technology risk
  9. Litigation risk
  10. International risk
  11. Reputation risk
  12. Potential lucrative exit

The challenging part of this method is finding an objective point of reference to measure each component. Starting with comparable methods, like the Scorecard Method or Comparable Transactions Approach, may help. 

7. Venture Capital Method.

Put yourself in the shoes of savvy investors seeking high returns within a set timeframe. The VC Method mirrors their perspective, focusing on maximizing their potential gain.

The Investor's Compass: VCs prioritize high returns in a few years, shaping their valuation approach. This method revolves around two key formulas:

  • Anticipated Return on Investment (ROI) = Terminal Value ÷ Post-Money Valuation
  • Post-Money Valuation = Terminal Value ÷ Anticipated ROI

Breaking Down the Code: Don't let these formulas intimidate you! Simply imagine:

  • Terminal Value: This is your ship's final destination – the expected selling price after the VC's investment fuels your growth. Estimate it using industry multiples or price-to-earnings ratios.
  • Anticipated ROI: This is the VCs' treasure chest – their desired return, like 10x their investment. Plug everything in, and voila! You have your post-money valuation.

From Dream to Reality: Remember your initial funding request. Subtract it from the post-money valuation, and you've reached your prized pre-money valuation – the starting point for your financial voyage.

In a nutshell 

Remember, no single method is a silver bullet. You’ll likely work through multiple methods and combine techniques to find a fair value. Don’t forget to leverage various company databases and your market research to triangulate the actual value of your startup. 

We hope we were able to give you more clarity on how to come up with a valuation of your startup that you can justify to potential investors, secure investments, and achieve sustainable growth.

 

 

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