Don’t believe the internet - there are two ways to value a startup. What a VC will pay, and the academic methods used to produce a 409a valuation.
While the two are related, it’s the VC that really sets the value, and then the valuation providers try to back into justifying it!
VCs take a different approach to valuing early-stage startups than traditional investors, investment bankers, academics and accountants. As a leading CPA firm serving VC-backed startups, Kruze Consulting understands the nuances of both approaches and their importance in the startup ecosystem - and our typical advice to founders raising venture funding is to focus on how VCs will value their startup. And for our clients who need a 409a valuation for stock option grants, it’s the more traditional/academic methods that come into play.
So let’s see what the current valuation market looks like for startups, referencing some data from Carta (and we’ve got more, including breakdowns of valuations by stage, on our startup valuation page).
Recent median startup valuations by funding round are:
These figures provide a snapshot of current market trends in startup valuations, and they reflect what VCs are willing to pay to invest. But, how do VCs decide how to value a startup?
Venture capitalists typically use a more market-driven approach to valuation. Traditional metrics like discounted cash flow (DCF) or balance sheet ratios are rarely used for early-stage startups. Instead, VC valuations are based on what the market will bear, often referred to as the “going rate” for companies in particular industries at specific stages with similar traction.
Eric Ver Pleog, a General Partner at Tunitas Ventures, explains this approach:
VCs often aim to purchase 15% to 25% of a company in any given round. VCs know how much money the startup is raising, and they know how much they typically invest. So their valuation method is incredibly basic - how much money the company needs to raise, then divide it by the desired ownership percentage (e.g., 25%) to arrive at the implied valuation.
Factors influencing VC valuations include:
This explanation is often pretty surprising to founders, who expect some sort of magical blackbox of valuation methodologies that VCs use to come up with what they will pay for a startup. While some venture investors may look at comparable companies and try to back into what the company will be worth at an exit, usually the going rate for a particular type of a company in a specific market environment takes over. And of course, getting a bidding war going, or being a well-known founder, can help improve the price. But, regardless, there isn’t a lot of science or financial precision in the earliest stages of venture investing.
Of course, this is actually good news. Most seed stage companies are burning cash, won’t be cash flow positive for years, only have minimal revenue - so if traditional valuation methodologies were really applied with rigor, then the startup would be basically worthless. And the VC investment would own a huge percentage of the company, leaving the founder with nothing. And VCs hate companies where the founders do not own very much, since that means that the founder is much more likely to leave the company.
Later-stage investors, usually starting at the Series C or D, will have enough financial metrics to be able to conduct more traditional valuation methodologies. Let’s dive into those methods, with a detour into 409A’s, which also should rely on academically solid valuations methods (even if the results may seem questionable).
While VC valuations are crucial for fundraising, 409A valuations play a vital role in tax compliance and setting stock option strike prices. These valuations, performed by independent providers, take a more rigorous, academic approach. And many of the methods that they use are also used by later-stage investors and public company investors (and accountants).
The importance of 409A valuations lies in their impact on a startup’s equity compensation strategy. They determine the fair market value of a company’s common stock, which is essential for complying with tax regulations and avoiding penalties.
Both 409A providers and later-stage investors use variations of the following methods, though their application may differ based on the startup’s stage:
Valuing startups presents unique challenges:
These factors contribute to the notion that startup valuation is “more art than science,” especially in early stages.
To maximize valuation and be prepared for both VC discussions and 409A valuations, founders should:
For more detailed advice on preparing for a 409A valuation, check out our comprehensive guide.
Venture investors have their own reasons for placing a valuation on a startup. So understand how they are different from what you may have learned in business school!
Here are some key considerations:
By understanding these valuation methods, preparing thoroughly, and balancing different stakeholder needs, founders can navigate the complex world of startup valuations more effectively. Whether you’re raising capital, granting stock options, or planning for future growth, a solid grasp of these concepts will serve you well in your entrepreneurial journey.
Remember, while VC valuations often drive headlines, maintaining compliance with 409A regulations is crucial for your startup’s long-term success and ability to offer competitive equity compensation. Understanding the cost of a 409A valuation and budgeting for it appropriately is an important part of your financial planning and resource allocation.