Apr 25, 2024
Venture Capital

Mastering Startup Valuations: A Comprehensive Guide

Michael Sable

n July 1, 2021, Olive AI, a healthcare automation startup, was valued at $4 billion after a $400 million funding round. On November 1, 2023, Olive AI shut down. Convoy, a freight startup that raised $900 million and was valued at $3.8 billion also shut down. And then of course - there’s WeWork. Everybody knows that story. Such occurrences in the fast-moving world of startups are not uncommon. 

The demise of these unicorns—startups valued at $1 billion—highlights just how difficult it is to truly place a concrete value on how much a startup is truly worth. This is a big part of why venture capital is such a risky business. So much of the wealth that seems to be created is ephemeral. Entrepreneurs can go from rags to riches and back again in a heartbeat. Valuation is actually as much art as science. It is also changing as traditional valuation methods are being challenged. 

This is a complex but essential aspect of the venture capital world that needs to be explored because ultimately the job of a venture capitalist is to foster the creation of enough value to justify the risky investments that they make. They cannot do this if they do not understand how best to value a startup.

7 Methods for Determining a Startup’s Valuation

In the realm of entrepreneurial finance, valuation is the process of determining the worth of a startup. This is an intrinsically difficult matter because startups operate in highly dynamic markets wherein there is a tremendous amount of risk and uncertainty. It is also challenging because the value of a startup is rooted in an assessment of the value of both tangible and intangible assets such as intellectual property, brand, etc. 

It can be very difficult because you never truly know what the fit will ultimately be between the tangible and intangible assets of the startup as the market rapidly evolves. For example, Yahoo! was a leader in the early days of the search engine race but was eventually supplanted by Google because the latter had superior technology and developed a better way of monetizing search. Billions of dollars of value evaporated because of a combination of poor business strategy and poor technology development by Yahoo! 

This shows how hard it is to value startups as even firms with enormous market value and initially dominant market share like Yahoo! can easily be supplanted. As Intel founder Andy Grove noted: “Only the paranoid survive.” 

How have startups traditionally been valued? There are a number of methods that have historically been utilized: 

1. The Berkus Method - Created by American venture capitalist David Berkus, the Berkus Method evaluates a startup through a detailed assessment of five key success factors: sound idea/basic value; prototype; quality management team; strategic relationships; and production rollout/sales.  

While a sound business idea is foundational, each of the other factors is supposed to reduce a critical risk: a good prototype reduces technology risk; a quality management team reduces execution risk; strategic relationships reduce market risk; and production rollout/sales reduce production risk. 

A monetary value is assigned to each of these five success factors and the startup’s valuation is the summary of these monetary values. The approach normally allocates a maximum of $500,000 per success factor for a maximum pre-money valuation of $2.5 million. 

The key value drivers are defined as follows: 

  • Sound idea: the problem the startup is trying to solve is obvious and a real pain point for many businesses/consumers 
  • Prototype: the startup has already developed an MVP
  • Quality management team: the founding team has demonstrated experience in the sector but has not built, nor exited a startup in the past.
  • Strategic relationships: the startup has limited partnerships with suppliers and/or partners for marketing its product
  • Product rollout or sales: the startup can’t add additional key features to the product or sell it to customers as it needs to hire more developers and a dedicated sales team

This method is designed to value pre-revenue or early-stage startups. For example: 

An example of a Berkus Method valuation


2. Bill Payne Valuation Method - This method is used by angel investors for pre-revenue startups. It takes the average valuation of all pre-revenue startups in the target company’s market and compares it to the pre-revenue valuation score of the target company.  A startup would be rated as follows: 

  • Management team 0 – 30%
  • Size of the opportunity 0 – 25%
  • Product/Technology 0 – 15%
  • Competitive environment 0 – 10%
  • Marketing/Sales Channels/Partnerships 0 – 10%
  • Need for additional investment 0 – 5%
  • Others 0 – 5%

The total score of the startup is the total of all seven of these factors which are then compared with the average pre-money valuation of all pre-revenue companies in the target company’s industry. The challenge is that in some nascent industries there may not be a sufficient number of comparable firms to generate a sound average for comparison.

3. Discounted Cash Flow Method - This method focuses on projecting the startup’s free cash flow and then an expected rate of return on investment aka the discount rate is estimated. The idea is to calculate how much that cash flow is worth. Since it is preferred that the startup have cash flow, it is usually utilized for Series B startups or above. 

In addition, since startups are new companies with high risk associated with investing in them, a high discount rate is generally applied to them and the future cash flows are then discounted back to present value. 

The high discount rates are designed to neutralize risk factors based upon assumptions about the business and emerging market trends. It is generally acknowledged that this is not a very reliable method of valuation as a lot of the projections are based upon assumptions that may prove to be invalid. The startup’s value is determined by summing up all of its expected future cash flows: 

4. Comparable Transactions Method - This is a method that is akin to that utilized in real estate. According to this methodology of startup valuation, a reference metric from a similar company in the market is selected and compared so as to estimate the startup’s value. For example, if a competitor business is valued at $5 million and it has 500,000 early users of its prototype then that means that each user is valued at $10 and this can be used as a benchmark to value the company. 

If the startup in a similar market has 250,000 users, then it would be valued at $2.5 million. This is often done in real estate markets where the value of similar domiciles with similar features and square footage is compared across markets to get a sense of value. Another example is to compare revenue multiples in similar industries. For example, it is not unusual for SAAS startups to be valued at 10x their revenues due to low cost of maintenance. Also, e-commerce startups are often valued at 3x revenues; hotel booking startups at 8x revenues and so forth. Indeed, these comparable valuations by industry are why some startups are strongly preferred by venture capital investors over others.

5. Book Value Method - At the other end of the spectrum is the book value method. As noted, most startups are a combination of tangible and intangible value. However, the book value method focuses only on an estimation of the value of the tangible assets of the company such as plant and equipment. As such, it is typically used to evaluate the value of startups that are going out of business.

6. Cost-to-Duplicate Approach - This valuation method involves taking into account all of the costs and expenses associated with the startup and the development of its products including the purchase of its physical assets. Comprehensively, these expenses are taken into account to determine the startup’s fair market value. However, this method does have drawbacks including: 

  1. Not taking into consideration the startup’s future potential by projecting financial statements of its future sales and growth.
  2. Not taking into account intangible assets along with tangible/physical assets. In an information driven world, intangible assets may have greater value than physical ones.

According to this startup valuation method, a startup is worth only as much as it will take to duplicate it. Only the tangible assets of the startup are considered. Basically, with the cost-to-duplicate approach, as the name implies, one is endeavoring to determine how much it would cost to recreate a startup elsewhere — minus any intangible assets like brand or goodwill. Critically, future market potential is not considered.

7. Risk Factor Summation Approach - Startups are risky. The risk factor summation approach values startups through a quantitative consideration of all the risks associated with the business than can affect the return on investment. Generally speaking, there are 12 risks to be evaluated and rated:

  • Management
  • Stage of business
  • Funding/capital risk
  • Manufacturing risk
  • Technology risk
  • Sales and Marketing risk
  • Competition risk
  • Legislation/political risk
  • Litigation risk
  • International risk
  • Reputation risk
  • Potential lucrative exit

Values are assigned to each of the aforementioned elements as follows:

  • -2 ………….Very negative
  • -1…………..Negative for scaling the startup and carrying out a successful exit
  • 0 ……………Neutral
  • +1………….Positive for scaling the startup and carrying out a successful exit
  • +2………….Very positive

The pre-revenue startup valuation will increase as follows:

  • By $250,000 for every +1
  • By $500,000 for every +2

And the pre-revenue valuation will decrease as follows: 

  • By $250,000 for every -1
  • By $500,000 for every -2

Once all of these risks are taken into consideration to the initial estimated value of the startup, the final value of the startup is determined.

All of these methods with their advantages and disadvantages highlight the enduring fact that startup valuation is intrinsically complex. Each venture capital firm and each venture capitalist will have their own bespoke methods buttressed by years of experience and the unique tricks that they have learned along the way.  There are however, a number of challenges that are common.

Some of the Challenges with Startup Valuation Methodology

Due to the high rate of startup failure and the large amounts of investment that are often involved, startup valuation is serious business. Not to mention the fact that entrepreneurs often devote years of their lives to these endeavors and the investments are typically quite illiquid for venture capitalists. All of the stakeholders need to have clarity in the valuation process. Amongst the challenges in valuing startups are: 

  • Insufficient Data: Unlike mature enterprises, due to their nascent level of development, startups typically lack historical information—particularly of a financial nature—so it is difficult to evaluate or predict their performance, capacity for revenue generation and profitability potential. In contrast, mature publicly listed business often have ample statistical data about their operations and finances that they are required by law to make available to regulators and potential investors. They are often evaluated using the EBITDA (earnings before interest, taxes, depreciation and amortization) formula:

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization 

  • Uncertain Future Performance: Due to the reality that startups operate in fast-moving and dynamic markets, it is very challenging to accurately predict their future growth. Ironically, startups that seek to disrupt markets with new technologies are themselves vulnerable to disruption by other startup with better technologies, better business models or a combination of both. This makes it difficult to estimate the size of the addressable market and the capacity of the company to obtain market share.
  • Lack of Comparables: Some startups with novel technologies operate or unique business models operate in markets in which there is literally nothing to compare them to. This makes valuation exceedingly difficult. For example, it is difficult to value many cryptocurrency startups because the technology is so challenging to comprehend and the economic activity occurs in opaque exchanges. This is why there has been so much fraud in this market segment and lofty valuations are now proving to have been so flawed. There has literally been nothing like this technology before so even the best venture capitalists may be fooled. 
  • Reliance on Multiple Funding Rounds: This is a major challenge. Many startups have multiple rounds of funding—sometimes too many. But the valuation of the company can change during each funding round depending upon market opinion, investor opinion, the company’s stage of development and so forth. Valuation at each funding round is a challenge in and of itself.
  • Bias and Subjectivity: Human beings make valuation decisions and as such their presumptions, prejudices, opinions, and subjective interpretations hold sway. Valuation is not a completely objective process. For example, each investor may have a different valuation of a startup based upon their risk tolerance and evaluation of its growth forecast.

These challenges point to the reality that valuation like venture capital as a whole is as much art as science and probably more of the former than the latter.

Pre-Revenue Startup Valuation Factors

In valuing a startup, venture capitalists will examine several key factors some of which have been examined above. Here is a more in-depth perspective of some of the most important ones for pre-revenue startups. Firstly, traction is critical. Due to the fact that startups don’t usually have revenues, venture capitalists are interested in the number of users that the startup has proven able to attract and the lower the cost of customer acquisition the better. 

If the startup can sustain its growth trajectory on a limited budget, then that is generally the sign of a high return on investment. However, a problem experienced during the recently ended era of low interest rates is that a number of startups used “blitzscaling” to artificially inflate or acquire users by subsidizing usage. For example, Uber used this technique to keep its initial usage costs low and induce consumers to switch to this novel mode of transport but it has severely hampered the company’s prospects for profitability as it made the company appear more viable than it actually was. 

Good startups don’t need artificially low interest rates or to throw a lot of capital and discounts at users to induce them to use the service or product. Rather the intrinsic value of the offering is sufficient to motivate consumers to buy the product or service.

A constant in venture capital is the imperative of having a good team. Information about the team is almost always more concrete and substantive than information about the product or service. The team should have a holistic and complementary set of skills required to grow the company: business strategy, technology, finance, sales, etc. 

Investors also look for founders with prior entrepreneurial experience which is why failure is not frowned upon in Silicon Valley. Ironically, financial capital is most attracted to high quality human capital. Relatedly, as proof as the capabilities of the team, startups must have a product or more precisely the demonstrated capacity to build one. To attract significant seed capital, venture capitalists will require a tangible working prototype as proof that the team is capable of executing on their business idea. 

Another green flag is good product-market fit in a growing or profitable industry. Often, for better or for worse, a high valuation is about targeting a trendy industry. Right now, that industry is artificial intelligence. A couple of years ago it was blockchain and cryptocurrency. Relatedly, the degree of demand in that industry is essential. 

Highly valued startups don’t compete in areas wherein there is oversaturated market demand with lots of competitors. Rather, they identify an underserved part of the market where there are few competitors and a critical problem that needs to be addressed. This has great appeal to venture capitalists.

Likewise, a key part of profitability is high profit margins. Investor look for industries wherein there are high profit margins and or businesses that are so efficient that they can generate high profit margins due to how they operate. This is why SAAS startup businesses are so popular—they have high profit margins and they are conduits for the ongoing artificial intelligence revolution.

New Startup Valuation Methods

With all of the unicorns that are rapidly going out of business, it has become apparent that traditional startup valuation methods are becoming increasingly obsolete. Part of the reason in terms of relevance is that there are now so many of them—there are over a thousand unicorns globally—and yet many of them have less than a million dollars of revenue:

At the height of the recent venture capital boom, many startups became so focused on obtaining unicorn status that their investors lost sight of what it means to be a great company. There are new, emerging valuation methods that are much more focused on that. One such methodology pioneered by Bessemer is the Centaur approach which leverages annual recurring revenue (ARR).  A Centaur is a well-valued business because it has $100 million ARR, good product-market fit, scalable go-to-market strategy, and a growing customer base:

These are all strong metrics that reflect a viable business. According to Bessemer, there are only approximately 150 Centaurs in the world which makes them seven time rarer than unicorns. In addition, the startups worthy of the best valuations have operational efficiencies of 1.5x or more; net retention of 120% or higher; and revenue growth of 125% or more.

Another emerging startup valuation method is customer-based corporate valuation. This method is somewhat diagnostic because it infers and incorporates the key determinants of corporate valuation—customer acquisition and their costs, retention and monetization—directly into the valuation model which traditional models do not. It also incorporates the latest techniques in Big Data as sophisticated predictive customer analytics are used to assess how well a company is acquiring new customers as well as retaining and monetizing them. This information is then placed into a standard discounted cash flow valuation model to generate an estimate of the overall value of the firm. While individual startups are data poor, entrepreneurship is now so widespread that there are a number of datasets that make it increasingly possible to make these calculations. 

The human capital plus market value method is both old and new. It entails calculating the value of intangible assets such as the ideas, know how, and experience of the team. This requires venture capitalists who are willing to spend the time to get to know the founders. Some venture capitalists may even require tests such as the Myers Briggs Type Indicator Assessment. Initially, venture capitalists are keenly interested in the people who are developing the product. Concurrently, a mathematical valuation is made on the capacity of the intangible assets to achieve viable market penetration of a substantial segment of the market. Those two assessments are combined to value the startup.

Multiplying gross profit by the competitor’s multiple in terms of industry, offering and revenue growth is another novel method. According to Kean Graham, the CEO of MonetizeMore: “Gross profit is a great indication of growth, company health, and market penetration while still properly valuing businesses that aren’t profit optimized because they consistently invest back into the business.” Hence, gross profit is a very valuable metric in startup valuation. According to this method, the startup is valued by looking for public companies that are most similar to it and using the aforementioned valuation formula.

Finally, there is the combo method which may be what most venture capitalists wind up using at the end of the day. This method involves agglomerating a bit of each of the techniques—both old and new—delineated herein and elsewhere. This will be done based upon the stage of the startup, the amount of data available about it and its industry, the level of confidence in the data analytics techniques available, and other factors. It’s about being eclectic and trying to approximate the truth of how best to value a startup using a diversity of approaches in a holistic manner.

There is no aspect of venture capital in which the humanity and subjectivity of the industry is more evident than in startup valuation. Each venture capital investor will make a different assessment of a startup based upon their appetite for risk, understanding of the dynamics of an industry, evaluation of a founding teams’ expertise and character, and evaluation of the technology and businesses model. 

In making these valuations, they bring their biases and prejudices with them. To be sure, the process of valuation is becoming more objective and more quantitative as Big Data and related techniques grow in their usage. But as we are coming to realize, these algorithms often replicate the biases in society. 

What is critical is to move beyond an obsession with valuation towards a more profound focus on what makes a good business. This seems to be happening as the era of cheap money ends and venture capitalists are forced to be more judicious in how they allocate capital. There is much more of a focus on not just user acquisition but on what about the startup’s product or service led users to want to buy it. 

Is that something that will be viable over the long haul or will customers stop making purchases once the product or service is no longer subsidized with an abundance of cheap capital? Beyond a focus on what makes for a good business, the art of sound valuation requires a diverse population of venture capitalists who can bring to bear the while array of experience and talents that can provide real insight into how innovation happens.

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