How to Value a Startup
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!
How do startup valuations work?
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
Recent median startup valuations by funding round are:
- Seed: $15M
- Series A: $42M
- Series B: $117M
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?
How VCs Value Startups
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:
- Market environment
- Stage of development
- Market size and potential
- Management team experience
- Competitive landscape
- Revenue and growth metrics
- Intellectual property
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).
How 409A Valuation Providers Value Startups
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.
Common Startup Valuation Methods
Both 409A providers and later-stage investors use variations of the following methods, though their application may differ based on the startup’s stage:
- Backsolve Method: This is usually the most common way that a 409A valuation provider values a startup. It basically takes the most recent price that a VC paid, and then discounts it to account for the special rights and privileges that the VCs get in their investment. The method involves modeling the company’s shares as a series of call options on the overall equity value, assigning probabilities to various payoffs, and discounting them to their present value. This complex analysis helps to “backsolve” the common stock valuation based on the most recent financing round. It usually results in a common stock valuation that is 25% to 35% of the preferred value.
- Market Comparable Approach or Market Multiple: This method compares the startup to similar companies that have recently raised funds or been acquired, or, more often, looks at public companies multiples. Factors considered include revenue, user base, growth rate, and market potential - but let’s be honest, it’s usually based on revenue. While popular among VCs, finding true comparables can be challenging for unique or early-stage startups.
- Discounted Cash Flow (DCF): Analysis DCF involves forecasting future cash flows and discounting them back to present value using an appropriate discount rate. While more commonly used for established companies. The challenge lies in accurately projecting future performance for early-stage companies, and the long time frame it takes to generate cash flow, since so many startups lose money. This is really not a great method, although academics love it.
- Cost-to-Duplicate Method: This approach calculates the cost of building a similar company from scratch, considering factors like technology development, team building, and asset acquisition. While objective, it often underestimates a startup’s potential future value and intangible assets.
- Valuation by Stage: Often used by angel investors and early-stage VCs, this method assigns valuation ranges based on the startup’s development stage. Most 409a valuation providers are not going to use this method.
Challenges in Startup Valuation
Valuing startups presents unique challenges:
- Lack of historical financial information
- Uncertain future performance in rapidly changing markets
- Limited comparable companies
- Dependence on future funding rounds
- Valuing intangible assets like intellectual property and brand value
- Subjectivity and investor biases
- Accounting for inflation and market trends
These factors contribute to the notion that startup valuation is “more art than science,” especially in early stages.
How Founders Can Prepare for Valuation
To maximize valuation and be prepared for both VC discussions and 409A valuations, founders should:
- Track key metrics: Focus on growth rates, customer acquisition costs, lifetime value, and other relevant KPIs for your industry.
- Build a compelling narrative: Clearly articulate your vision, market opportunity, and competitive advantage.
- Understand market comparables: Research valuations of similar companies in your space.
- Demonstrate traction: Show progress in product development, customer acquisition, and revenue growth.
- Protect intellectual property: Secure patents, trademarks, and other IP that adds value to your company.
- Develop financial projections: Create realistic, well-supported forecasts that show your path to profitability.
- Create a robust business plan and strategic planning process.
- Consider strategic alliances to enhance your market position.
- Develop prototypes or minimum viable products (MVPs) for mobile application software or other tech products.
- Highlight your addressable market and potential market share.
For more detailed advice on preparing for a 409A valuation, check out our comprehensive guide.
Remember that how VCs value startups is unique
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:
- Understand the differences: Recognize that VC valuations and 409A valuations serve different purposes and may result in different values. And remember that maximizing the 409A isn’t really the goal; instead you want to get to a reasonable, defensible common stock price.
- Timing matters: Be aware of how recent funding rounds can impact your 409A valuation. Learn more about post-money valuations and their impact.
- Plan for equity compensation: Consider how your valuation will affect stock option pricing and your ability to attract and retain talent.
- Seek expert advice: Work with experienced advisors.
- Consider the impact of private equity and various financing options on your valuation.
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.
