Startup Valuation

Startup valuation is part science, part art, and part business strategy. Learn how your company is being priced by investors.

Startup valuation is a notoriously difficult challenge, especially for early-stage companies. It's as much an art as it is a science.
The headline numbers you might see in the news where "XYZ startup raises $ millions at $$$ millions valuation" is the investor determined valuation. That means it's the price that new investors were willing to pay to acquire shares of the company. You'll often hear it called the fair market value.
That price is different from the value of employee shares. Employees generally receive common equity that doesn't have many protections or rights. Investors typically negotiate for preferred equity that includes protections and rights. The investor-determined price is for the preferred equity.
The price for common equity is typically determined through a process called a 409A valuation, a value appraisal conducted by a third party that the IRS accepts as a "fair basis" for value. The price for common equity is almost always less than the preferred price because the common equity has fewer rights. The third-party essentially backs into the common equity price - they start with what the investors paid for the preferred equity and subtract out the value of the additional protections and rights.
How venture capitalists arrive at the price they pay for preferred equity changes based on the maturity of the startup.

How Venture Capitalists Value Startups

When we talk about valuation, it's important to differentiate between pre and post-money valuations.

Pre-money is the new value of the startup before you include the additional money raised from investors. Post-money is the startup value including the new cash. For example, if a startup that was previously worth $10 million doubles in value to $20 million and raises $2 million, we say the company has a new pre-money valuation of $20 million and a post-money valuation of $22 million. If the company had raised $5 million instead, the pre-money valuation wouldn't be affected but the post-money valuation would increase to $25 million.

The pre-money valuation is a better indication of the increase in value per share from the startup's efforts to be successful rather than new "value" created by venture capitalists investing money to help the company fund future growth.

Valuing pre-seed and seed stage startups, before the company has meaningful revenue, is a challenge. There's a wide variety of valuation methods. Most focus on a combination of the investor's confidence that the team + idea could be successful and the potential size of the company if it were successful.

Three popular methods for early-stage valuations are the Berkus Method, the Scorecard Valuation Method, and the Risk Factor Summary Method. They're different ways of weighing early indicators of startup success including the quality of the founder team, sales process maturity, technology risk, and funding risk.

Early-stage startups and investors are increasingly punting on assigning valuations. Instead, they use a Simple Agreement for Future Equity (SAFE). A SAFE is an agreement from the startup to provide shares to investors at a future date in return for cash today. That date is determined by a trigger event such as a capital raise that includes the startup selling preferred equity. It's an agreement that allows both investor and startup to delay pricing the shares until the startup makes more progress and other valuation methods become more appropriate.

Once a startup starts generating meaningful revenue, it becomes easier to value. Valuation methods based on revenue and the cash the company generates start to be used as early as a Series A and play a more central role for investors in later stages.

Discounted cash flow multiple is the most common method to value more mature companies. To determine a valuation using a discounted cash flow (DCF) you first project the expected cash the company will generate over time - revenue minus expenses - and then use a discount rate to discount the future cash flows. The discount rate includes the opportunity cost of investing in that startup versus somewhere else and the riskiness of the cash flows, i.e. if they're likely to happen.

As you might expect, DCFs are highly subject to assumptions. Small differences in the projected revenue or expense growth rates can have massive implications on the valuation. Most venture capitalists will therefore create multiple scenarios where the company does better and worse over time to ultimately arrive at a valuation. Those types of scenario comparisons can also help investors think through how sensitive their valuation is to assumptions around revenue, expenses, and growth rates.

As companies mature and create a longer track record of cash flows, it becomes easier to project future expected growth. Not that it's easy, just easier.

Sometimes, startups fail to meet projections. Perhaps revenue doesn't grow as quickly or expenses grow too quickly. Or it may be that the discount rate has changed because of macroeconomic conditions outside of the startup's control. In those scenarios, startups can be forced to take a down round when they raise money again.

A down round is when the per share price decreases in between funding rounds. It can be a painful experience for employees, founders, and existing investors as they are forced to take significant dilution because the startup has to sell more shares than it intended to raise capital. You can learn more about funding and down rounds here.

Thankfully, most startups avoid down rounds. That comes from not only successful execution on the part of the startup, but also from getting the valuation right at each round. Ultimately the goal of the valuation is to fairly value the startup given both the success to date and expected success going forward.

Too high a valuation and the startup will struggle to grow into it before it runs out of cash. Too low and the founders and employees will sell more of the company than they needed to. Just right and the startup will be set up for success.

Until the last decade, valuations were typically only updated concurrently with a fundraising event. Today, with robust secondary markets for shares in startups, we have strong valuation indicators even in between fundraises.

Secondary Market for Startup Equity

The primary market is how a startup raises money from investors - it sells shares of the company in return for cash. The equity compensation you receive is also a primary market. The startup is "selling" you shares instead of more cash compensation as payment for the services you provide to the company.

Secondary markets are different. A secondary market is one where the seller is an existing shareholder, not the startup. That means the shareholder receives cash rather than the startup. They're the most common way existing equity holders convert their equity to cash. In 2021, the four largest marketplaces for secondaries facilitated over $20 billion in sales.

You can learn more about early liquidity options, including secondary markets, forward contracts, and asset-backed loans here.

Secondary market transactions can be useful indicators of a startup's valuation, but there are some caveats. The market for public equity - the "stock market" - is big. Billions of shares worth hundreds of billions of dollars are traded every day. That creates strong signals - the prices at which transactions happen are generally representative of the companies' valuations.

Secondary markets for startup equity are less robust. Transactions happen infrequently, startup restrictions on secondary transactions may affect the price, and share class exchanged may not be public. All this messiness means that the signals about a startup's valuation are not as strong.

Just like in the public stock market, startup shares may trade significantly above or below the most recent funding round valuation. Large transactions involving institutional buyers and sellers are generally better indications of a startup's current valuation.

But ultimately treat the secondary market indications as what it is - signal. The buyers and sellers may not have access to the information that you do or they may have other considerations that cause them to value the shares differently. The secondary market can tell you the price right now for that specific transaction, but value is what you think the shares are worth.