Emma McGowan
The question of startup valuation is one that founders struggle with, especially in the early stages. If you’re a pre-profitable startup company — or even pre-cashflow — how can you figure out what your company is worth? Let's dive in to different valuation methods for early stage startups.
One way is to think about “value” as something that exists beyond monetary terms (especially for pre revenue startups).
“Valuation is both art and science,” Lili Balfour of Atelier Advisors says. “The science is the easy part — researching valuations for comparable companies and constructing a revenue or EBITDA multiple. The art is more subjective. How strong is the team? How probable are the leads in the pipeline? How innovative is the technology?”
Those are the more nebulous aspects of “value.” Another aspect is the valuation of similar companies that are already out in the market.
“Startups, by definition don’t have a long track record of revenue, earnings or cash flow (if any) so much of the valuation exercise is conducted by looking at the marketplace of comparable companies and understanding how the industry for a type of startup values the companies within it,” Georgene Huang, CEO and Cofounder of Fairygodboss, says.
Those are the first steps of figuring out how to value a startup: Think of value beyond monetary terms and then think explicitly about the monetary value of similar companies. But, like so many things in the startup world, there’s more than one way to figure out startup valuation for pre revenue startups or early stage startups.
Check out the startup valuation methods these ten founders and investors recommend for figuring out how much your company is likely to be worth.
1. Standard Earnings Multiple Method
“The method that I prefer for startup valuation is a standard earnings multiple, with additional consideration being attributed to recurring revenue models. This valuation method provides the greatest insight into free cash flow and how that metric will drive incremental value to a purchaser.
In my market, the multiple typically ranges between 5 to 8x the past three years average profit (yearly) but in SAAS businesses, ranges may fall in the 8 to 12x range.
Besides the standard profit model, other factors to consider are previous debt incurred or funding rounds as well as the intellectual capital of the product or service. In situations which strategic buyers are present, and a company has some sort of patent or proprietary technology, startup company valuations can grow tremendously without profit being on the books.”
–Craig Smith, Founder & CEO, Trinity Insight
Additional notes/resources:
- How To Value Your Startup Using Comparables by Nathan Hurst
- CBInsights, Crunchbase, and Pitchbook are great resources
2. Human Capital Plus Market Value Method
“Figuring out startup valuation is no easy task for an investor because most of them have very low intangible/intangible assets ratio (ex venture capital firms). In other words, a potential startup investor should calculate a value of ideas, know-hows, and human potential of the team.
There are two ways I value the projects: Firstly, I can get to know the team and their expertise, I assess the people who develop the project (when you work in a common sector of economy with those who you assess, e.g. IT, it could be a pretty simple task). Secondly, I can perform a purely mathematical valuation based on the obtainable market volume. When an investor knows at least some rough estimations, he can easily extrapolate a startup’s potential, and thus, future profits hidden in today’s valuation.”
–Andrew Zimine, CEO of Exscudo
3. 5x Your Raise Method
“In Rare Carat’s conversations with VCs, we were surprised to find that it was not so much the ‘value’ of our company from metrics like monthly revenue — but more about the ‘stake’ the investor is receiving for their money — with a rule of thumb that investors will desire something in the neighborhood of 20 to 25 percent. So to oversimplify, we’ve found the value of a startup is roughly five times the amount you are raising.
The temptation here is to maximize your valuation, but this creates a new problem for you in the future when you go to raise your next round (bad things happen to founders in down rounds). So shoot for a strong and reasonable valuation, but don’t shoot yourself in the foot.”
– Ajay Anand, CEO and Founder, Rare Carat
4. Thinking About The Exit Method
“As a founder, I want to build a big operational business and have enough stake when it’s sold. My method is control based: What valuation leaves me enough stake on the exit. I have seen enough situations when the business needed to raise, but due to wrong evaluations on early rounds and subsequent terms on the late rounds, founders did not have an incentive to prove startup worth or grow the company further.
I build a model cap table with the main stages my business should go through (depends on the business model). That gives me a tool for sensitivity analysis on what valuation and other terms are acceptable on early rounds of pre revenue startups to have a good exit. Of course, I assume that on Series A and later the valuation will be based on revenue growth or EBITDA.”
–Konstantin Savenkov, CEO Intento, Inc.
Additional notes/resources:
- For the exit method, also called liquidation analysis or waterfall analysis, read more here.
- Here’s a template to model it out.
- Which reminds us, you probably want to put together your cap-table in order to start to understand exit scenarios. Here’s a great free resource.
5. Discounted Cash Flow Method
“As a Certified Business Appraiser with 20 years of experience, I have done many startup valuations for in many different industries (IT, bio-tech, consumer products, etc.). My preferred valuation method is the Discounted Cash Flow Method. The key to using this valuation method correctly for valuing startups is:
1. Estimating the total market for the startup company’s product or services and its expected revenue growth.
2. Forecasting market share acquisition across a timeline.
3. Forecasting cash flow by identifying the startup’s fixed and variable costs and future working capital and capital expenditures needs.
With all of the forecasts, we can’t just take into account the most optimistic/pie-in-the-sky outlook. We need to take into account that the majority of startups fail completely — and a significant amount of the non-failures just squeak by. We then apply a discount rate to these forecast that accounts for the risk inherent in them. We determine this rate according to the subject’s lifecycle stage (seed/startup/early/expansion/later). All of these numbers should be based on empirical data sources that are as trustworthy as possible.
Constructing a valuation in this way helps the founder have meaningful valuation conversations with investors and steers the conversation toward the real assumptions that drive value. Without this type of valuation, everybody is just shooting from the hip when talking about how to value a startup.”
–Chaim Borevitz, CBA, CEPA, MBA, Managing Director, Abrams Valuation Group, Inc.
Additional notes/resources:
- Investors will often combine a DCF with another method to understand the valuation. One variation of this methodology is the Chicago Method which combines both a DCF and comparable multiples.
- Also see: How to value your deal like an investor
6. Comparison Valuation Method
“Anchoring valuation in recent and comparable M&A deals or venture investments is often the most common way both founders and investors look at startup valuation, in my experience. Given the lack of much alternative, I think this is a fair way of looking at startup valuation.
Of course, the downside of this valuation approach is that a startup’s valuation can hugely change depending on the market conditions, so be sure you know which valuation method is right for your startup company. For example, a certain type of startup might be in vogue versus another kind of startup, which will make a lot of startup valuation subject to investor whims and trends. However, this broader phenomenon is not unique to startups and exists in all financial markets.”
–Georgene Huang, CEO & Cofounder, Fairygodboss
Additional notes/resources:
- Similar the multiples method. Check out those resources and don’t forget to leverage online databases through the library or local university. Here’s more info on comparables.
7. Customer-Based Corporate Valuation Method
“I would recommend using an emerging methodology called ‘customer-based corporate valuation.’ It is more diagnostic and accurate because it infers and incorporates the most important determinants of corporate valuation — customer acquisition, retention, and monetization — directly into the valuation model, while traditional models do not.
Customer-based corporate valuation values a business by using sophisticated predictive customer analytics to uncover how well a company is acquiring new customers, and retaining and monetizing existing customers. It then plugs this information into a standard discounted cash flow valuation model to come up with an estimate of the overall valuation of a firm.”
–Daniel McCarthy, Co-founder and Chief Statistician of predictive analytics firm Zodiac.
8. Combo Platter Method
“Being in the Boston area, there is a bend towards more conservative financing vehicles (e.g. equity over convertible debt) as well as more conservative valuations. Having started our company while at Babson College, we first did our financial models by the book, but were quickly told that valuations at our stage were not particularly tied to our financial assumptions, but rather things in the real world. The key metrics investors were looking for were tied to us ‘de-risking’ the business. Did we have a product? Were we the right team? Was this the right time and is the vision big enough?
We answered these and then backed them up with real-world valuation numbers from three sources. First and most reliable, was looking at Angel List for past ‘enterprise’ ‘AI’ ‘Boston’ deals and we came up with a best/moderate/worst case for a valuation. This was balanced with the Berkus method and the Risk Factor Summation method, which helped us refine the right valuation range. From there we were able to prove startup worth and negotiate with our lead investors knowing our zone of possible agreement based on real-world factors and ended up raising a $1M seed round at an agreeable valuation.”
–Rich Palmer, co-founder of Gravyty
Additional notes/resources:
- More info on the Berkus method with images
9. Gross Profit x Competitor’s Multiple Method
“The valuation method I prefer for valuing startups is gross profit multiplied by a multiple based on industry, offering, and revenue growth. Gross profit is a great indication of growth, company health, and market penetration while still properly valuing businesses that aren’t profit optimized because they consistently invest back into the business.
For example, we valued our business by looking for public companies that are most similar to our business. We then used the same valuation formula they used but attributed to our gross profit. The formula we used:
MonetizeMore Gross Profit (Last 12 months) x 5.91 (Competitor’s Multiple) = Current Valuation
When looking for similar companies, they must have a very similar business model, industry and customer base. In our case, we chose a competitor with a similar product.”
–Kean Graham, CEO of MonetizeMore
Additional notes/resources:
10. Best For Me Method
“There are a variety of valuation methods to value a business including: book value, multiple of revenue, multiple of earnings, and more. As a buyer or seller, you will obviously want to select the valuation method that favors you most — assuming that the person on the other side of the transaction is going to use the method that favors you least.
Typically, however, each industry has a standard it favors that standard will likely govern the end value. A local retail business will probably sell for 1-2 times annual earnings plus assets/property that convey with the sale. A tech startup with high growth potential is likely going to be a multiple of future earnings based on the rate of growth it currently exhibits.”
–John B. Dinsmore, Ph.D., Assistant Professor, Marketing, Raj Soin College of Business at Wright State University
Bonus Valuation Method
As mentioned briefly above, there are multiple valuation methods to value a startup, and one not mentioned (but worth noting since this is arguably the most common startup valuation approach) is the Venture Capital Method that was developed in 1987 by Bill Sahlman.
If working with a venture capital firm, you should know how they calculate valuations. Venture capital firms use this valuation method to establish an understanding of the value of a startup using this basic framework. In addition to the venture capital method, a VC Term Sheet is used to define the specific conditions of venture capital investments between an early-stage startup company and the venture firm itself.
So how should you Calculate your startup’s valuation?
As you can see, different people have different valuation methods for figuring out startup valuation. However, the differences are pretty small — a slightly different calculation here; a shift in perspective there.
But many of them take both the human and the monetary elements into consideration when figuring out the “value” of a startup. Nathan Lustig, Managing Partner at Magma Partners, takes that idea to the next level.
“Obviously valuation matters, but if you find the right partner that you think will actually help you in areas other than just money, think twice about just taking the highest offer,” Lustig says. “Also, read the fine print. Many term sheets include other provisions that make the same valuation offer extremely different.”
So, remember: You need to make both human and monetary considerations. But make sure you never forget the human, even when you’re spending hours and hours on cap tables and calculations to value a startup.
Because it’s the people who really make your startup what it is.
Final notes:
Startup valuations often require information from other companies that are similar to yours in order to determine the true value of a startup. Investors (at venture capital firms and beyond) will look at competitors and other companies in the same industry to best understand how your company and business model fits into this landscape.
They will look at financials, funding rounds, how much those companies raised, pre revenue valuations, or post revenue valuations. Valuations don't necessarily define [founder success](https://www.startups.com/library/expert-advice/what-does-founder-success-feel-like) — there is a lot more to it than that. You actually have access to those same resources to find that information at your fingertips via Public Library Databases.
If you don’t have a library account, you seriously should go create one. Public libraries have a whole repository of research databases at your disposal with public/private company information. Same with university libraries too.
Oftentimes, universities will have even more databases with better data since they have larger budgets. Either way, go create a library account or go find your old university email and create those accounts.
You will have full access to this trove of valuable knowledge.
- For example, San Francisco Public Library has a whole slew of research sources that may have market data, market reports, and much more. https://sfpl.org/index.php?pg=2000028601&tab=subject&cid=1
- Another example, the Columbus Public Library (Ohio) has a whole bunch too – http://www.columbuslibrary.org/research
- Try Google searching for your city + public library + research database. Examples (“Columbus public library research” or “San Francisco public Library research database”).
Some of our favorite databases that you may find within the list of the library’s research databases include:
And lastly, master the basics of startup finance terms and practices [here](https://www.startups.com/library/playbooks/startups-finance).These resources contain industry research reports, public/private company financials, funding rounds, and more. If you’re searching for evidence on how to value a startup, these free resources are a great place to start.
* Article Updated: 3-16-22 *Also worth a read:
- Startup Valuations: What’s My Seed Stage Startup Worth?
- Your First Order of Business? Plan a Startup Exit Strategy!
- Shutting Down Your Startup: The Exit No One Talks About
- Managing Insane Growth: Master class by Matt Mullenweg
- Zero to IPO: Master class by George Northup
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Thank you. Most informative.