Business Valuations: Methods, Examples & How-To Guide

Valuing a business is a blend of art and science. Investors and founders know that valuations must take hard numbers and soft factors into account. Negotiations like funding rounds, where valuations are core to discussions, need to include both elements.

But the complex process of agreeing a valuation isn't restricted to funding rounds. Valuations recur regularly for companies and can often involve in-depth dialogues with tax authorities.

The reporting and filing commitment with valuations can place additional burden on finance, tax and legal teams. For example, US businesses that offer equity to employees need to complete 409A valuations annually or more often if there are events like funding rounds, and in the UK, EMI valuations must also be completed annually.

So why go to all this effort? Well, valuations are critical to people's equity packages, meaning they have a real impact on share ownership as a company grows. Here, we analyse some of the most common ways to value scaling technology businesses, giving you the tools to understand exactly what your business could be worth.

Why do companies need valuations?

A company's valuation is perhaps the best way to quantify its success and the value it is creating – or promising to create – for stakeholders. Valuations are an important external signifier of a company's progress: after all, it's often headline news when a company hits a valuation milestone, like when a new unicorn (a private company worth more than $1 billion) is created, or when Apple became the world's first trillion-dollar company.

Valuations are especially important for companies offering equity to employees. Without a valuation, employees can't understand the nature of the opportunity their equity offers. And in fundraising conversations, successfully securing investment depends on being able to agree on a valuation.

Pre-money vs post-money valuations

When we discuss some common valuation methods below, you'll see post-money and pre-money valuations mentioned. So what's the difference, and why do they matter?

First, some definitions. A company's post-money valuation is the updated or current value of the business including money committed as part of a new round of financing. The pre-money valuation refers to the value of the company before an external investor's money is sitting on the cap table.

Pre-money and post-money valuations matter because of how investors' money contributes to valuations.

Let's now dig into how companies' valuations can affect equity and share ownership, as well as the valuation techniques that can work best for different businesses.

Learn about our online cap table management software for large enterprises.

Popular valuation methods

There are many ways to value companies, and as companies scale, different valuation methodologies may work better at different times. Let's examine some of the most influential valuation methodologies, starting from a company's earliest days.

The Berkus method

Back in the 1990s, investor Dave Berkus became frustrated with traditional ways of assessing the value of start-ups. It was an era of pioneering technology firms but none of the textbooks provided an adequate guide for would-be investors.

So, Berkus designed his own method to give pre-revenue valuations to very early-stage startups:

This framework is an example of a scorecard valuation method, which puts a general value on each of the most important elements of a young business, acting as a proxy for future potential. It does not include robust analysis of financial metrics: the business models are simply too new to support this kind of analysis.

Berkus himself said, “These numbers are maximums that can be 'earned' to form a valuation". These figures are from a long time ago and haven't been adjusted for inflation. However, the Berkus method is a solid way to get to approximate startup valuations for companies in the earliest phase of their development, with little more than a business plan.

The venture capital method

This way of valuing companies is predicated on a hypothetical future liquidity event where a return on investment is crystallised for investors (such as venture capital firms). The venture capital method uses the following formula:

Post-money valuation = exit value / anticipated return on investment (ROI)

The exit value is the anticipated price the business might be sold for in the future. It is usually expressed as a revenue multiple or earnings multiple. Similarly, ROI usually represents a multiple of the initial investment. This methodology is reasonably well established for early-stage private companies.

The discounted cash flow method

Discounted cash flow (DCF) valuations are based on a forecast of the cash a company is predicted to produce in the future. The value of the business is pegged to current and expected cash flows, minus a discount rate.

First, cashflows are assessed, minus operating expenses and tax. Then, present and future cash flows are discounted using weighted average cost of capital, to arrive at a value for the enterprise. (The rate of the discount reflects business risks and uncertainties

DCF is a proven methodology for valuing relatively stable businesses in more predictable sectors like banking, commodities or industrials. In spaces where forecasting cash flows is more difficult, DCF modelling will likely become more complex. Generally, the younger and less proven the company, the higher the discount rate investors will apply to revenues and cash generated.

Market multiples

The market multiples approach uses recent fundraisings, acquisitions and other transactions involving similar companies as a benchmark for a business's market value.

This gives an investor scoping a deal a set of clear signals about what their peers – in other words the market – are willing to pay for a similar opportunity.

For example, if a Series B artificial intelligence business in the Netherlands is valued at 10x its revenues, then this can function as a benchmark for other artificial intelligence businesses of comparable size, scale and ambition – or for other Dutch businesses at the same stage of development. As different variables are important to different investors, the valuation will be discussed and adjusted for each comparable company. But the original valuation provides a helpful starting point.

Like other techniques designed for slightly more mature businesses, many market multiple valuations require a projection of sales or earnings, which will be specific to the company in question. They can be very useful for investors taking the temperature of a sector or geographic market when considering a new deal.

Valuations at Ledgy

Obtaining valuations can be complex and time-consuming for companies. Making sure all valuations are financially credible and rigorously independent is absolutely critical. That's why at Ledgy, we partner with Aranca, a financial advisory and valuations specialist with 20 years of experience handling valuations for Fortune 500 companies and scaling startups alike. Learn more about Ledgy's Aranca partnership – and our other integrations – here.

Valuations and financial reporting

Valuations are closely interrelated with equity and share ownership.

Companies need to understand accounting standards like US GAAP and IFRS 2. In IFRS 2 reporting, for instance, companies must calculate the expenses linked to equity compensation and prepare their financial statements. As well as inputs like vesting and grant terminations, valuations are a core component of IFRS 2 reports. So as a company, your valuation is key to delivering accurate and compliant financial reports.

Learn more about our financial reporting software.

(Did you know? Ledgy offers in-app IFRS 2 reporting, including guidance for companies on the right way to input the fair market value of equity grants.

Valuations and down rounds

As companies grow and scale, employees could be forgiven for assuming their equity stakes will increase in value. And often, this is the case, but not always. In recent months, we have seen more down rounds in the tech industry, for instance. A down round occurs when a company raises money from investors at a lower valuation than their previous fundraise. When this occurs, some employees who joined the company after the last funding round may find that their equity is 'under water' and effectively worthless.

A 'down round' does not mean the company in question is in trouble: it can simply be a consequence of a changing market environment. But a lower valuation can seem like bad news, and so companies should be clear with employees about what an updated valuation means – both for long-serving team members that have significant wealth tied up in equity, and newer joiners whose equity may not be worth as much as they'd hoped and imagined. More information in Ledgy's down round deep dive.

Share plans

Some share plans include conditions that specifically tie equity to valuations, such as growth shares (also known as hurdle shares). When hurdle shares are in place, employees qualify for full ownership rights over their equity stakes only once the company's shares surpass a 'hurdle' price that is set by the company. (Companies setting up hurdle shares are able to run these schemes and set their hurdle price on Ledgy.)

Several other grant types (such as EMI and CSOP schemes in the UK) need regular valuations in order to remain compliant. Ledgy lets you add these valuations easily in-app:

In summary: valuations have real impact beyond the numbers

There are so many variables that can be used to adjust a company valuation, both qualitative and quantitative. Handling valuations can be tricky, but with Ledgy companies have tools at their fingertips that can ease headaches and save time in completing the valuation process. Different valuation methods are liable to give different results, so founders and senior leaders should prepare for constructive dialogue with investors and other stakeholders (such as tax authorities) when fundraising and reporting on financials.

It's important to remember that valuations also have consequences for the company and employees. A higher or lower valuation has a tangible effect on people's equity stakes. Valuations are one of the most powerful signals of a company's progress, and proactive communication can place a valuation in context for team members.