How to Pick The Right Startup Valuation Method?
By Lior Ronen | Founder, Finro Financial Consulting
Startups at different stages vary in their financial performance, business model stability, and growth potential.
Some are already generating revenue, and some are still pre-revenue.
Some are profitable, while some are still losing money.
Some have a positive operating cash flow, and some still depend on cash inflows from current and potential investors.
Some startups already know how they want to monetize their idea, and some are just trying to figure it out.
It's unreasonable that all of these use the same valuation method to value their startup.
Let's go stage by stage and see what valuation method(s) suit it.
How startups calculate their value changes a lot as they grow. When they're just starting with an idea, they don't really need to set a value right away. They can get money from different ways that don't need a set value.
As startups get a bit bigger, in the early stages, they start to use some simple ways to guess their value. This could be what angel investors think it's worth, or more number-focused methods by bigger investors.
When they're more established, in the middle stages, they use their sales and other numbers to estimate their value. And for the really grown-up startups, they use even more detailed methods because they have a lot of information and a clearer idea of how they're doing.
Each stage has its own best way to figure out what a startup is worth.
Between Idea to Pre-Seed
Super early-stage startups have specific unique characteristics.
Since they are in the very early days of the business, many aspects are not finalized or tested.
These are typically pre-revenue startups that are in the proof of concept or early pre-alpha stages of product development. They have only a rough idea of which business model to use, how to monetize their idea or whether their idea has any future potential.
They expect to have high growth rates, but asking a founder in this stage to build an EBITDA projection or user base growth estimate is like shooting in the dark: you might get it right somehow, but you probably won't.
In these ultra-early stages of the business, startup companies do not necessarily need a valuation and can postpone it to later.
How?
By financing their business from their pockets (bootstrapping), taking a small bank loan, or raising funds in an unpriced round.
What is an unpriced round?
A priced round is when a company sells a certain number of shares at a specific share price. A priced round is a traditional transaction where a buyer receives shares in the company, and the company gets money from the investors.
However, in an unpriced round, the company and investors use a mechanism, typically through SAFE or convertible notes, that allow the company to receive money from investors. However, investors don't receive their shares immediately, but in a future priced round at specific terms, they agree on.
So in most cases, startup companies between the idea stage and pre-seed rounds don't need a valuation.
Here’s a quick re-cap on the differences between a SAFE and a convertible note:
| Aspect | SAFE | Convertible Note |
|---|---|---|
| Definition | An investment tool that gives investors the right to future equity in the company. | A short-term debt that converts into equity, typically in conjunction with a future financing round. |
| Equity Conversion | Converts to equity at next financing round or liquidity event, usually without a maturity date. | Automatically converts to equity at the next financing round, subject to certain terms. |
| Interest | Does not accrue interest. | Accrues interest over time, which is usually converted to equity. |
| Maturity Date | Typically does not have a maturity date. | Has a maturity date by which it must convert or be repaid. |
| Valuation Cap | May have a valuation cap. | Usually has a valuation cap. |
| Discount Rate | May include a discount rate for early investors. | Typically includes a discount rate for early investors. |
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Pre-Seed and Seed
These days the funding rounds of the pre-seed stage and seed stage are extended to include multiple small funding rounds.
The business is not much more advanced in these stages than in the previous section. The startup is probably in the pre-alpha or alpha stage with only a bit more clarity on the business model or monetization plan.
In these stages, it is also very common to raise in unpriced rounds, but we also start to see priced rounds.
In the pre-seed stage, we'll see angel investors, accelerators or micro-VCs investing either through SAFEs and convertible notes or traditional equity rounds. While startups don't immediately need a valuation for unpriced rounds (they will need one in the future), they need to agree on a pre-money valuation with potential investors buying equity.
In this case, there's usually a difference between angel investors and VCs.
Angel investors typically use qualitative valuation methods to assess different aspects of the business, such as the management team, marketing, future potential of the product, technology risk, and strategy to estimate a rough startup's valuation.
These methods typically include the Berkus method, the Risk Factor Summation Method, and The Payne Scorecard method.
VCs usually use more quantitative methods like the Venture Capital Method (VC method), which works the valuation back from an expected exit value, or the comparables method, where they use the company's revenue forecast and revenue multiples of similar companies to value the business.
| Aspect | Pre-Seed | Seed |
|---|---|---|
| Focus | Idea validation and early development. | Product development and market validation. |
| Funding Source | Founders, friends, family, and sometimes angel investors. | Angel investors, early-stage venture capitalists, and accelerator programs. |
| Company Maturity | Very early; often just an idea or concept. | Developed beyond concept; early signs of a viable business. |
| Product Development | Initial product development, often not market-ready. | Advanced product development, possibly a working prototype or MVP (Minimum Viable Product). |
| Revenue | Typically no revenue; pre-revenue stage. | May have some initial revenue but not yet profitable. |
| Investment Size | Smaller investments, often less than $1 million. | Larger investments, often ranging from $1 million to $3 million. |
Series A and B
The business is more mature in these stages than in the previous sections. The product is typically in the late stages of alpha, beta, or even MVP, and we'll see fewer pre-revenue companies.
The company either found a product-market fit (PMF) or is working towards it but has a clear path and a plan for how to get there.
Businesses in these stages usually clearly understand their business model and monetization plan. They have some historical financial data to get them suitable enough direction of costs and have some insights on the user acquisition process.
Startups in these stages start seeing what works better and what does not in their marketing strategy. They know which marketing channels work better, which channels need a boost and which channels they should experiment with.
The business is much clearer in this stage. The company has a much better view of its business and financial performance, and financial and business projections are totally doable.
The company can estimate with a little bit of effort and a certain degree of error:
How many users could it acquire, and from which channels?
What the expected conversion rates and churn rates are?
How much does it need to invest in marketing or R&D to achieve the following milestones?
What skill sets are missing from current staff and will be required in the future?
Investors in series A and B are typically early-stage venture capital firms, family offices, and current investors from previous rounds. The vast majority of these rounds are priced and require a pre-money valuation.
In this stage, where the company has a general idea of its growth plans but might not have a clear insight on when it will reach operating, or EBITDA profitability, the most helpful valuation method is the comparables method.
In most cases, we'll only use the revenue multiples since most companies in this stage still have a negative EBITDA.
However, if the company we're valuing is EBITDA profitable, we'll add the EBITDA multiples to the analysis.
Series C to Beyond
Here we're talking about late-stage startups. These startups are much more mature than the previous examples we mentioned. They have a clear path to profitability and know which areas to invest in to grow the top line.
These startups have good enough insights into their clients, what they're looking for, how to monetize it, and what additional features or products could further benefit them.
Investors in this stage include late-stage venture capital firms, private equity funds, family offices, and investors from previous rounds. These investors are more sophisticated than investors in earlier stages and have more financial and business information to work with when assessing company valuations.
They're either making additional investment into a current portfolio company or a brand new investment into a new startup company.
Unlike early-stage companies or pre-revenue startups, we could expect startups in this stage to be already EBITDA profitable or have some clear path to achieve it, and most of them should have a positive operating cash flow.
When we combine all the factors of sophisticated investors, plenty of business and financial data, solid insights into future actions, positive EBITDA, and operating cash flow, we unveil a broad set of options to value the business.
Typically we apply several methods to improve accuracy and reduce the weights of inherent biases that every technique has.
These are the primary valuation methods you can use in these stages:
The comparables valuation method is an excellent method to start with. It's a market multiple approach that applies to 99% of cases, is easy to explain, and adds a significant portion of actual market data to the analysis.
The great thing about this method is that it fits early-stage startups, late-stage startups, and mature companies.
In this method, you calculate a startup’s valuation by applying the company’s financial projection on market multiples. Typically, in this method, we use the revenues and EBITDA multiples of similar companies in the niche, market, or sector.
The discounted cash flow method (DCF) is the second one we'd go with. It is notorious among many tech investors, but it's a powerful tool that has become an industry standard.
While many investors and founders like to hate the discounted cash flow, it delivers the goods every single time. Since it's an industry standard, many investors, analysts, and executives look for a DCF valuation in a late-stage startup.
It's important to remember that when calculating a DCF for a private company, you also need to calculate its terminal value and discount rate or the Weighted Average Cost of Capital (WACC) for a private company, which requires a slightly different analysis than in a public company.
Suppose the startup has several substantial revenue-generating assets, whether these are physical assets or intangible assets. In that case, we could use a Net Asset Value (NAV) method, which calculates the valuation of each asset separately and then the aggregate value of the assets combined in the company.
Other less common startup valuation methods include the risk factor summation method, the first Chicago method, the cost-to-duplicate approach, and others. Nevertheless, I left them out of this guide since they're not as widely used as the ones I introduced above.
Conclusion
In conclusion, the process of valuing a startup is nuanced and evolves significantly as the company progresses through various stages of growth.
From the initial idea and pre-seed stages, where valuation often hinges on future potential and may not necessitate immediate precise valuation, to the more mature stages of Series A and beyond, where sophisticated methods like comparables and discounted cash flow become essential.
Each stage of a startup's lifecycle presents unique financial characteristics and challenges, necessitating a tailored approach to valuation. Understanding the appropriate valuation methods for each stage is crucial for both founders and investors to make informed decisions.
This dynamic approach to valuation not only reflects the evolving nature of a startup's journey but also aligns the valuation process with the company's current state, future potential, and the interests of its stakeholders.
As the startup ecosystem continues to flourish, this tailored approach to valuation remains a vital tool in the strategic development and growth of emerging companies.
| Stage | Characteristics | Valuation Methods |
|---|---|---|
| Idea to Pre-Seed | Idea validation, proof of concept, pre-revenue. | Unpriced rounds (SAFE, Convertible Notes), no immediate need for valuation. |
| Pre-Seed and Seed | Initial development, possibly pre-alpha/alpha stage, clarity on business model. | Qualitative methods (Berkus, Risk Factor Summation, Payne Scorecard) for angels; Quantitative methods (Venture Capital Method, Comparables) for VCs. |
| Series A and B | Late stage of alpha/beta, possibly MVP, finding product-market fit, beginning to understand business model. | Comparables method (revenue and EBITDA multiples), more structured financial and business projections. |
| Series C to Beyond | Mature startups, clear path to profitability, substantial business and financial data. | Comparables, Discounted Cash Flow (DCF), Net Asset Value (NAV), multiple methods for accuracy and bias reduction. |
