Valuing a tech start up is not an easy process. Investors and founders both know that business valuations blend hard numbers and soft skills, involving metrics and gut instinct in equal measure. This is particularly true in early-stage companies, but valuations are frequently re-assessed in more mature scale-ups too.
Some think that valuations distract from the metrics that really matter to startups, like revenue, growth rate, and churn. But a valuation can make a real difference to a startup's momentum and internal culture. And valuations are fundamental to dictating the value of employees' equity packages, meaning they have a real impact on share ownership as a company grows.
Here, we analyze some of the most common ways to value startups, giving you the tools to understand exactly what your startup could be worth.
Why do startups need valuations?
In young, volatile companies, nothing is straightforward. Understanding the potential in a very early-stage startup means thinking about the idea, the size of the market, competitors, the founding team, and much more beyond the money the business is making.
Founders focused on growing their business need to focus on challenges like revenue growth, pipeline, and hiring. But to do this at scale, many startups need angel investors and venture capital firms to back their plans. And in fundraising conversations, successfully securing investment depends on being able to agree on a valuation.
This article will help you understand some of the different ways valuations are calculated. We'll also dig into how companies' valuations can affect equity and share ownership. So which valuation technique might work best for your business? Let's read on.
Different startup valuation methods
As a startup grows, 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 invented his own method of valuing pre-revenue startups:
This framework 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," implying a maximum of $2 million for a pre-product business and $2.5 million post-product launch. 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 an approximate valuation for a company in its earliest phase, with little more than a business plan.
The venture capital method
The venture capital method of valuing companies is based on a hypothetical future liquidity event where a return on investment is realized. This method is useful for investors that seek to gauge the size of the opportunity, .
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 multiple of revenues and/or earnings. Similarly, ROI usually represents a multiple of the initial investment.
The venture capital method is tried and tested, especially for startups with initial revenues and the potential for a big exit in the future.
Discounted cash flow (DCF)
Discounted cash flow 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 businesses in stable and predictable sectors like banking, commodities or industrials. But in the world of startups, with high growth and unpredictable revenues, using DCF comes with caveats.
When it is difficult to forecast cash flows two or three years down the line, discounted cash flow valuations may make less sense. For example, investors in young technology companies may apply a comparatively high discount rate because of the innate risks of calculating cash flows in a more volatile early-stage environment. In addition, many DCF models assume long-term growth rates of around 4%. Early-stage startups are likely to run much faster than this, adding further complexity to DCF modeling.
The market multiple approach uses recent fundraisings, acquisitions and other transactions involving similar companies as a benchmark for a tech startup'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 20x its revenues, then this can function as a benchmark for other artificial intelligence businesses of comparable size, scale and ambition. If any of these variables vary, then the valuation can be adjusted appropriately.
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. As we've seen, the value of a startup can't always be reduced to a revenue multiple, but they can be very useful for investors taking the temperature of a sector or geographic market when considering a new deal.
Ledgy's valuation approach
At Ledgy, we help entrepreneurs and high-growth companies manage equity and share ownership. Because we think about share ownership all the time, we wanted to develop an easy way to value companies that is based on your actual shares.
The valuation formula is very simple:
Company value = number of fully diluted shares x latest share price
We take the number of fully diluted shares on a company's cap table, and multiply that number by the price of a share at the most recent funding round.
Using this methodology, growing companies have an approximate real-time, post-money valuation that does not demand complex assessments of intangible assets and forward earnings projections, which are often highly variable.
This method is not a full replacement for a 409A or IFRS 2 valuation completed by an independent appraiser. (Ledgy does help companies store and share all data and documentation relating to 409A and IFRS 2 valuations. For more, check out our help article.)
Valuations and share ownership
Company milestones like funding rounds are often marked with new valuations. While this certainly makes an attractive press release, there are real-world consequences for the employees and investors in a business, as the value of their equity stakes has changed.
Of course, a higher valuation means that an employee's shares will be worth more. Great news! But some companies implement conditions that specifically tie equity to valuations, such as 'hurdle shares'. When hurdle shares are in place, employees see capital gains from their stakes 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)
Occasionally, there are tangible effects for employees and other stakeholders that stem from a higher (or lower) valuation. Companies with increasing valuations should be clear with employees about what the new valuation means for them.
In summary: valuations have real impact beyond the numbers
We have covered a few common valuation methodologies in this piece, as well as briefly addressing the actual impact of valuations on share options. Valuing a startup is inevitably a blend of art and science, but being confident about the value of your business can make a real difference for companies.
At Ledgy we are empowering companies, employees and investors to take charge of equity and share ownership. To read more articles like this, head to our blog, and to learn more about Ledgy, take a tour of the Ledgy app today.
Stay up to date! 🎉
Subscribe to our newsletter and recieve the latest insights on the equity world