How much is your company worth? If you’re an entrepreneur trying to raise equity investment, this is a crucial question to answer. For early-stage businesses this can be a challenging process, especially when there’s little or no financial history to use as a benchmark. However, while there’s no single universal formula for calculating valuation, it’s possible to determine a figure that makes sense for you and aligns with investor expectations.
In this article, we discuss the key considerations when valuing your business, and outline commonly used valuation methods for pre-revenue and post-revenue companies. The objective is to equip you with practical frameworks and tools to support informed decision-making during investment negotiations.
Why startup valuation matters
No valuation method provides a definitive, correct answer, and it’s often said that estimating the value of a business is more of an art than an exact science. It’s normal to use a combination of methods to arrive at a value range that can then be negotiated.
Another thing worth noting is that market forces like supply and demand can play a huge part in determining the value of your company. However, as fundraising takes time and can be a business distraction, holding out for a higher valuation may not always be feasible and you might risk running out of cash. Moreover, when you’re fundraising, getting the highest valuation possible shouldn’t be the main focus of your efforts. Paul Graham, co-founder of Y Combinator, writes in his essay How to Raise Money:
“Fundraising is not the test that matters. The real test is revenue. Not only is fundraising not the test that matters, valuation is not even the thing to optimize about fundraising. The number one thing you want from phase 2 fundraising is to get the money you need, so you can get back to focusing on the real test, the success of your company. Number two is good investors. Valuation is at best third.”
Not only is valuation not the top priority, but setting it too high can potentially create significant disadvantages. An inflated valuation may make it harder to raise further funding rounds, because unless you raise a down round (which you or your investors may be reticent to do, plus investors will often have anti-dilution rights that will be triggered in this scenario), the bar will be set higher each time. Institutional investors can be more sensitive to valuation than individual investors, who may have incentives like tax breaks that make a higher valuation easier to justify.
Be mindful that an artificially high valuation can be a barrier to raising the funds you need to succeed later on. There’s also a possibility that it could make it more difficult to sell your business when you want to exit. If your company doesn’t grow as much as expected, it may not deliver a strong enough return to make investors willing to sell. Below we have outlined some common valuation methods for pre-revenue and post-revenue businesses:
Pre-revenue valuation methods
There are several methods you can use to value a pre-revenue startup, including:
Berkus method. In the absence of all financial information, you can assign a financial value to five key areas of the company and then add them up. These areas are: sound idea, prototype, quality management team, strategic relationships, and product rollout or sales. You would then total the assigned pound values. For pre-revenue companies, the maximum value per aspect should be no more than £250k.
Scorecard valuation. This method is similar to the Berkus method but relies on a points system. Each fundamental aspect of the company is given a score out of 10, and then the answers are averaged. That score then relates to a predetermined valuation based on the points, for example 7/10 might equal £700k, assuming the 10/10 value is £1m.
Risk factor summation method. A lesser-known valuation method, but well worth mentioning. From a portfolio perspective, investors say 1 in 10 investments will be a huge success, 3 or 4 in ten will return a multiple of c. 1-2x investment, and the rest will return nothing. Knowing this, investors can use statistical concepts to calculate the valuation, based on portfolio risk.
Post-revenue valuation methods
Once your startup begins generating revenue, more traditional valuation methods become applicable. These are some methods you might consider using:
Discounted cash flow. A discounted cash flow is the sum of all future cash flows for 5 or 10 years, with each of those cash flows being discounted by a certain percentage. The higher the discount rate used, the riskier the investment. For established companies, this can be as low as 10%, but for startups, this can be up to 50%.
Venture capital method. This method starts with the end in mind. The aim here is to determine the exit price and then reverse engineer the calculations until you reach a pre-money valuation.
Comparable / multiples. A common approach is to compare a fundamental metric of a startup to others. In this example we will use revenue. If an analyst’s research reveals that recent transactions in the market show that a company in your sector sells for 6-8x their revenue, then a similar multiple may be used for your own company. Before this can be implemented however, there are several considerations, such as:
Quality of earnings. Are their earnings sustainable and comparable to your own?
Size of company. Startups carry significantly more risk than established companies. Therefore, just as in the discounted cash flow method, a discount factor is used.
Similarity of offering. Are you comparing apples and oranges?
Growth rates. Fast-growing companies can command higher multiples. There are many reasons for this, such as higher expectations of future cash flows, higher demand from investors, and - if first to market - the opportunity to increase market share quickly.
Market ownership. Companies who own significant market share in newly created markets usually experience very high multiples, such as Facebook, Spotify, or Uber. Even though these companies may operate in the same sector, using these companies as comparable multiples is not advised due to their ability to operate at scale and compete aggressively.
4. Net book value. Quite simply, take your assets and minus your liabilities. It’s unlikely a startup would use this method, but if they do, it’s usually for liquidation purposes.
As you can see, there are several ways to calculate your startup’s value. Whichever method you choose, don’t forget the main purpose of the whole exercise: to get cash into your business and ensure a fair exchange of value in the process.
Good investors will always want to make certain that founders or management teams are adequately incentivised. They’ll seek to protect management and re-up their equity stake if they don’t feel that they’re incentivised enough. Capitalisation tables can often be completely restructured in later rounds. The main goal now is to get the cash you need and grow the business with the help of your investors.
