Like beauty, value is in the eye of the beholder. Unlike beauty, value is not determined according to personal tastes alone. A startup’s valuation is critically important for both founders and investors as this number determines the amount of equity that needs to be transferred to raise money – and the amount of money that can be raised.
There are a number of factors at play that make startup valuation inherently tricky. You can’t really base calculations on the performance of comparable companies or technologies, like you would for more mature organisations. Available historical data is minimal at best. Multiple funding rounds and fluctuating valuations between them muddy the waters further. All in all, it’s a complex process. But not to worry, we'll walk you through it!
Key challenges in startup valuation
No crystal ball: Startups often work in fast-changing markets, making it hard to predict future growth.
Beyond compare: Startups often use new technologies, so finding similar companies to compare is difficult.
Limited financial history: Many startups don’t have long financial records, which makes traditional valuation methods less useful.
Up & down funding rounds: Startups often need several rounds of funding, and each round can change the company’s value.
In the eye of the beholder: Valuations vary a lot depending on assumptions, investor opinions, and economic conditions.
Common valuation methods
Without a crystal ball, how can the future value of a startup be predicted? Let’s have a look at 8 common methods of varying complexity, each with their strengths and weaknesses.
An overview of the methods, their uses and limitations. Image copyright PWC
1. Fixed range
Does what it says on the box: provides a ballpark figure within a fixed range up to 2.5 million EUR. This method is based on a checklist of 5 factors:
- Good idea
- Good team
- Working prototype
- Established strategic relationships
- Initial sales traction in the market
Each of these factors is given a certain score up to 500k EUR.
Pros: very easy
Cons: very generic
2. Cost-to-Duplicate
Literally answers the question "how much would it cost to recreate this company from the ground up?". While this is fairly straightforward for physical companies, it is less so for SaaS or similar businesses with largely intangible assets - although the overall cost of development could be used to represent the cost of the software. Even simpler is to just use the pure accounting value of the equity
Pros: straightforward, supported by facts & figures
Cons: ignores future sales and intangible assets which may hide the real potential
3. Comparable Transactions
Here, we compare the startup with recent transactions in the market. For instance, what does the seed funding round look like, or was a similar company acquired for a certain amount: these provide a benchmark for valuation.
Pros: supported by actions of others in the market
Cons: potentially comparing apples to oranges
4. Scorecard
Building on the comparison method, we use the benchmark set by competitors to compare the specifics of the startup. For example, a stronger management team or tougher competitive environment means adjusting the valuation. The outcome (in this example 1.23) is used as a multiplier to refine a more basic method such as the fixed range approach.
A risk factor summation adjustment (= a list of risks startups have to manage) may also be applied to reflect potential risks more accurately. Each point can have a value attached to it that either adds to or detracts from the basic calculation.
Pros: fully customizable, based on real-world data
Cons: it can be difficult to benchmark all factors correctly, there is risk of double counting
5. Multiples
This method uses financial metrics like EBITDA or revenue and applies a multiple based on industry standards. For example, SaaS companies might be valued at ten times their revenue, depending on growth stages and margins.
Pros: straightforward, widely accepted in negotiations
Cons: this approach is highly dependent on factors such as sector, region, and macro economy
6. Pre and post money
This method is used to understand how new investments impact a startup's valuation. The pre-money valuation represents the company’s value before new capital is invested, while the post-money valuation is calculated by adding the investment amount to the pre-money valuation. This approach helps determine the investor's ownership percentage and the dilution effect on existing shareholders, making it essential for negotiation and planning in startup financing.
Pros: useful in defining the stakes for new and existing investors during funding rounds
Cons:risk of losing sight of the bigger picture due to short-term thinking of the immediate effect of the investment and concerns about dilutio
7. VC Method
Developed by Harvard Professor Bill Sahlman, this method estimates post-money valuation by dividing the expected exit value by the anticipated ROI. It’s particularly useful for investments in startups that are ready to scale proven business and where high returns are expected.
Pros: aligns the valuation with the ultimate goal of most early-stage investors: a successful exit
Cons: designed from the VC’s perspective, relies heavily on assumptions of future exit value and RO
8. Discounted Cash Flow (DCF)
This method discounts future cash flows to their present value using a desired rate of return. It is more suitable for established companies with predictable cash flows but may be too complex for early-stage startups with uncertain revenue streams.
Pros: takes a long-term view, incorporates time value of money, focuses on intrinsic value based on actual expected cash flows instead of market comparisons
Cons: highly sensitive to assumptions about future earnings, difficult to apply to early-stage startups with unpredictable cashflow, does not account for market conditions
The art of the deal valuation
Understanding these basics can help founders and investors navigate the valuation process with more confidence. Startup valuation is more art than science. It is a complex, subjective process where different methods can produce significantly different results.
Investors usually have their own (mix of) methods that are averaged or weighted together. Or, they simply require a minimum range of shares for their usual investment levels and try to get the best deal within that range.
For founders, understanding their business's unique value drivers and the risks will help in preparing for negotiations with investors.
Always keep in mind the strengths and limitations of each method because while valuation is a critical component of startup growth and investment, it is not an exact science. Ultimately, the value of the startup is what one party is willing to sell it for, and what another party is willing and able to pay for it.