Understanding Startup Valuations

Startup valuations can be as mysterious as they are momentous. Take Flow, a yet-to-be-built real estate company. It was valued by investors at over $1B even though its founder, Adam Neumann, is a morally dubious enigma who left his previous venture, WeWork, in tatters. 

When Uber made its public debut three years ago, it fetched an $82B valuation on Wall Street, despite never turning a profit in its decadelong history.  Amazon’s $8.5B acquisition of MGM, on the other hand, seems like common sense with assets like Legally Blonde and Rocky at stake. 

Whether you’re going public, looking for a buyer, or raising investment, getting a handle on how valuations are done will enable you to get the best deal for your company. 

Pre-money valuation 

A pre-money valuation is the value of a company before it receives outside investment. Potential investors often conduct research and come up with calculations of what they think the company is worth. The company may reject that figure and wait for a higher pre-money valuation from a different party. 

On the other hand, a post-money valuation is the value of a company after it receives investment. Whether a valuation figure refers to pre- or post-money makes a difference in the number of shares an investor will own in a company.

For example, if the pre-money valuation of a startup is $1m and the investor puts in $250k, the post-money valuation will be $1.25m — and the investor receives 20% of the company (250k / 1.25m). But if $1m is a post-money valuation, then the investor will own 25% of the business.

Pre-money valuations should not be confused with pre-revenue valuations -— a valuation done when the company is yet to make any sales — which are common with early-stage startups. 

How to calculate the valuation of a startup 

Valuation for pre-revenue businesses 

Since pre-revenue startups don’t have data points on sales and earnings, valuations are more art than science at this stage. There is no industry-standard methodology or formula; while some investors say they consider factors like market size, others admit to a “gut-based” approach.

For investors who prefer more formal techniques, they may use the Scorecard Valuation Method or the Berkus Method. 

The first step in the Scorecard Valuation method is to work out the average pre-money valuation for businesses in the same sector and region (e.g., B2B SaaS in California). You could look at recent funding rounds and acquisitions on AngelList or Crunchbase to work out a number. For a broad example, the median US seed stage startup’s pre-money valuation is $10m.

Next, you compare the startup to other businesses in the same sector and region using the following variables: 

• Strength of the management team (0-30%)
• Size of the opportunity (0-25%)
• Product/technology (0-15%)
• Competitive environment (0-10%)
• Marketing/sales channels/partnerships (0-10%)
• Need for additional investment (0-5%)
• Other (e.g., customer feedback) (0-5%)

The percentages represent the relative importance of each factor. If you determine that the team is 25% better than its average competitor, then use the number 125%. Strength of the management team makes up 0-30% of the total score, so to calculate the weighted score for this factor, multiply the 125% by 30% to get to 0.375. 

Do this for each factor, and you’ll get to a total score. 

(Source: Angel Capital Association)

Finally, you multiply the total score by your baseline valuation. In this example, the total score is 1.24, which, multiplied by the baseline $10m, results in a valuation of $12.4m.

Similarly, the Berkus Method allocates a numerical value to variables that are otherwise difficult to quantify. The original version, which comes from Dave Berkus, looks like this:

(Source: Dave Berkus/ Berkonomics)

This version of the Berkus Method is based on the assumption that a pre-revenue business is worth a maximum of $2.5m, but the values and variables can be adjusted according to the industry and market trends. 

For example, look at a startup like Trial Library, an oncology clinical trials company that recently raised seed funding. Suppose the maximum value of a business at this stage and in this sector is $5m. It follows that you should allocate up to $1m to each variable. 

Trial Library has a sound idea that incentivizes patient referral and participation ($1m). One founder is an oncologist and experienced health researcher, and the other has experience in the health industry ($1m). The business has the support of key partners including the Association of Community Cancer Centers ($1m). Say they have a prototype but it needs work ($0.5), and they have yet to roll out the product or make any sales ($0). 

The valuation calculation would therefore be:

1 + 1 + 1 + 0.5 + 0 = $3.5m

Two more variables that can influence a valuation at the pre-revenue stage are the founder’s ability to pitch and the amount of interest from other investors. Therefore, founders should speak to as many potential suitors as possible to solicit multiple competing offers.

Valuation for revenue-earning businesses

When a company starts to generate revenue, the valuation will be based more on financial data. Some of the data investors could look at include:

• Total revenue
• Month-over-month growth in sales
• EBITDA (earnings before interest, taxes, depreciation, and amortization) — a measure of profitability
• Customer lifetime value (CLV) — how much a company can expect to earn from the average customer over the course of their entire relationship
• Cash flow
• Churn rate — loss of customers over a period of time
• Burn rate — how quickly a company is eating through cash before becoming profitable
• Customer acquisition cost

George Moulos, managing director of Ecommerce Brokers, says his brokerage looks at two main variables when valuing a business:. 

1. Valuations of businesses in the same sector and region (e.g., wellness apps in the US or pet D2C ecommerce retailers in London)
2. Financial performance of the company in the last 12 months

Startup valuation revenue multiple 

A common way to look at revenue-generating startups is the Market Multiple Method. It’s based on the assumption that similar assets have a similar value.The calculation looks like this:

Value of the business = revenue multiple x TTM (trailing 12 month) revenue

Revenue multiples are calculated based on the performance of other businesses in that niche. Investors can track multiples that public companies are trading at, as well as multiples that private companies sold for. 

For example, a D2C pet brand operating through Shopify could have been valued at 4-5x revenue this past January, says Moulos, because the pet-product ecommerce niche was booming following major growth in pet ownership during the pandemic.   

But multiples change depending on market conditions. For instance, the pet niche has not done as well recently, so the multiple has dropped to 3.8-4.5x. You can get a rough idea of which revenue multiple might apply to your company by looking at similar firms on marketplaces like Flippa and Empire Flippers. 

In addition to revenue multiples, other details of the business such as market share, market trends, and traffic sources may also be considered, but those variables won’t have a big impact on the valuation unless there is a major weakness in the businesses. 

“For example, if it’s a dropshipping business with no defensibility against competitors, no trademarks, no patents, no custom designs, no exclusivity agreements with suppliers, that will bring down the valuation massively,” says Moulos. 

Similarly, you can apply multiples to other metrics like EBITDA or net earnings to calculate a valuation. 

Startup valuation methods 

There are many different valuation methods. Each has its own strengths and weaknesses; therefore, an investor may try multiple methods before reaching a final valuation. 

Market capitalization formula 

A common valuation method for public companies, this formula multiplies the total number of outstanding shares by the price of a share. Microsoft, for example, has 7.45B shares outstanding and a share price of about $279 at time of writing, so the market cap value of Microsoft is $2.08T. 

Discounted cash flow method

DCF, or the discounted cash flow method, involves forecasting the future cash flow of a business then “discounting” it to get the present value. The formula for DCF looks like this:

(Source: Investopedia.)

Future cash flow is calculated by looking at your available cash balance at the start of the period, adding to that an estimate of how much cash will come in (e.g., sales) and subtracting your expected costs. Because this is an estimated figure, DCF can be inaccurate. 

WACC — weighted average cost of capital — is usually used for the discount rate. Simply put, WACC is the average rate a company expects to pay to finance its assets. Factors that influence WACC include:

• The interest rate that a company pays on its debt
• The rate of return that investors require on their investments
• The tax rate the company pays on its income
• The ratio of the company’s debt to its equity

Risk factor summation method

This calculation is based on 12 risk areas associated with an investment. As with the scorecard method, you need to start with a baseline valuation, then give each factor a score.

A score of -2 indicates a very negative outlook for that factor, while -1 is negative, 0 is neutral, +1 is positive, and +2 is very positive. The valuation increases by $250k for every score of +1 and by $500k for every +2. Conversely, scores of -1 and -2 decrease the valuation by $250k and $500k, respectively. The risk areas are:

• Management
• Stage of the business
• Funding/capital
• Manufacturing
• Technology
• Competition
• Sales and marketing
• Legislation/political
• Litigation
• International
• Reputation
• Potential lucrative exit

A US company that relies on microchips from Taiwan, for example, might get a -1 for international risk based on the current tensions between China and Taiwan. If the baseline valuation for a company in that sector is $10m, the -1 score will then drop the value to $9.75m. 

Cost-to-duplicate method

This method reaches a valuation by asking, “How much would it cost to build this exact business from scratch?” The calculation includes all expenses involved in developing the company’s products/services (e.g., recruitment, salaries, product testing) as well as any physical assets (e.g., offices, inventory, factory). 

It does not include intangible assets such as brand value, talented employees, or patents. It also doesn’t take into account the business’s future potential. As a result, cost-to-duplicate tends to produce lower valuations, as it excludes the prospects of innovative companies grabbing more market share or introducing more products as time goes on. 

Getting the best valuation 

Here’s some expert advice for startups who are looking to get a top-notch valuation. 

Don’t: 

• Pay for an expensive valuation report from an accounting firm if you are a young pre-revenue business. It’s not worth it.
• Speak to your ideal investor in the first week of fundraising. Save them for later when you’ve refined your pitch after talking to other investors.
• Be too discouraged by talks of a recession. Investors may be tightening the purse strings, but there’s still plenty of capital around.

Do: 

• Think about more than just valuation when choosing a suitor. Consider what they bring to the table in terms of experience and vision, and how they’re funding the investment or purchase (cash, loan, etc.). 
• Concentrate on operating as profitably as possible while maintaining growth prior to selling your business. In the current economic climate, investors are putting more focus on financial performance.
• Take six months to fix the holes in the business (e.g., improve SEO, get trademarks) before you look to sell.
• Be patient. It’s taking businesses a little longer to raise funds in a turbulent market. Getting the best possible valuation will take time, so don’t jump at the first offer. 

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