Startup Valuations: Breaking Down the Methods

I recently found myself writing about oddly specific topics of venture finance and felt the need to establish a proper foundation. So here we are, starting with the mother of all topics: Valuations.

Let me state the most important fact first: Valuations are the result of negotiation, not calculation. There are a number of valuation methods, of which I will introduce a few. If you are raising a priced round, I would recommend you first read into negotiation tactics and determine a ballpark range. If you then still want to do the exercise, let’s go for a ride.

Categories of Valuation Methods

Conceptually there are 3 categories of valuation methods:

- Asset-based Approach: Think of it as the money you would need to reconstruct the company. This includes cash at hand, consumables, machines, intellectual property. Startup valuations are commonly based on expectations. Many great companies are light on assets and often have significant goodwill/intangible assets which are notoriously hard to price. Therefore, let’s disregard asset-based approaches.

- Income-based Approach: More useful, yet also limited are income-based approches. These are essentially all discounted cashflow methods including all its adaptations. The most commonly used one is the VC method, where you also consider the exit proceeds (!) at a given time (!) in the future. Since startups typically don’t distribute any profits, at our fund we just take the projected exit value at the projected exit time and discount it. This should in theory lead to the current valuation of a company. Now, what will the exit value be and when will it happen? We typically look at comparable companies in terms of industry, product, etc. and from there come up with these values. This is however speculative and the actual range of the exit value can be huge. Concluding, while income-based approaches can be helpful, they are highly speculative since the values needed to perform the calculation have a huge error bar.

- Market-based Approach: Another important and often useful category are market-based approaches. We use 2 methods, (a) we benchmark the company aspects of the company (say team, market, product) and both compare this to another company and their valuation and a pre-defined maxiumum valuation we would be willing to pay for a 10/10 company, (b) revenue multiples (if the company makes any revenues even; we found that other multiples such as EBIT or EBITDA don’t make too much sense for early-stage companies), where we simply multipling the revenue of a company by an industry-specific multiple.

Lastly, I want to mention a hidden champion: The dilution method (or at least that is what we call it). In a nutshell, you take the size of the round and assume a standard dilution (in Seed stage typically 20%) which yields a ballpark valuation.

Income-Based Approach: The VC Method

To begin with, the VC method can be seen as a bastardized version of the Discounted Cash Flow (DCF) method. Rather than discounting future free cash flows, the VC method focuses on discounting the exit value of the company. While some variations of the VC method do consider future cash flows, these are typically much smaller than the exit proceeds and thus have a limited impact on the overall valuation. As a result, the primary focus of the calculation is on the exit value. The VC method begins by estimating the potential exit value of the company, which is the value at which the company is expected to be sold.

The calculation is done by discounting the estimated exit value back to the present using the internal rate of return. The discounting formula used is:

where n is the number of years until the exit and IRR is the discount rate / internal rate of return.

Exit Value & Time

Determining the exit value is undoubtedly the most challenging and uncertain aspect of the VC method. While VCs may have a sense of potential exit values — such as whether a company has “unicorn potential” — they certainly do not have a crystal ball. This step is, in essence, another exercise in valuation under uncertainty.

One effective approach is to examine comparable transactions — exits of companies in similar industries with comparable market positions and growth ambitions. Acquisitions are the most common exit route, and acquisition prices are often publicly disclosed. By looking at a few comparable transactions, averaging the exit values, and applying a margin of safety, one can arrive at a more grounded estimate.

Another common method is to use a multiples-based approach, applying industry-dependent multiples on projected financial figures. This can be reasonable if the projections are reliable. However, for early-stage, seed companies, projections are often too speculative to be trusted.

When estimating the time to exit (n), it is practical to rely on the company’s roadmap. It is wise to apply a safety margin of one to two years, given the uncertainties involved. It’s important to note that the time to exit has a substantial impact on the current valuation, as the discount rate applied is typically quite high.

Discount Rate / IRR

Once the exit value and time is estimated, the next step is to determine the internal rate of return (IRR), which reflects the level of risk the VC is willing to accept. Early-stage startups are inherently risky and venture is a winner-takes-it-all game. Therefore, VCs seek high returns, typically ranging from 20% to 50% (see table), depending on the perceived risk and the stage of the company. There is a good (German) study from Zellmann, Prengel, Lebschi (2014) that summarizes common values of the IRR depending on company stage and fund size.

Conclusion

The VC method is a practical tool for valuing startups, especially in the early stages where traditional valuation methods may not be suitable. However, its effectiveness hinges on the accuracy of the assumptions involved. While the VC method offers a straightforward approach, it’s crucial to recognize its limitations and to consider using it in conjunction with other valuation techniques. An important insight is that your company’s current valuation is closely tied to its perceived ambition and exit potential.

Market-Based Approach: The Scorecard Method

The Scorecard Method is a widely used approach to valuing startups, especially when there’s limited historical data. It works by comparing a startup to similar companies, scoring key factors such as the team, market, product, and traction. Each of these elements is weighted based on importance, and the company is rated relative to a benchmark. This rating is then used to adjust a maximum valuation figure, giving a structured way to arrive at a final valuation.

When implementing the Scorecard Method, we use two approaches:

1. The Original Scorecard Method

Here, we compare the company in question to a similar company whose valuation is known or can be reasonably estimated. The company is scored across six predefined dimensions: (1) Team, (2) Market & Opportunity, (3) Product, Tech & IP, (4) Traction, (5) External Environment, and (6) Deal

Each dimension is rated from 0–10, where 5 means the two companies are equivalent in that area. If the company being valued scores all 5s, its valuation should match that of the comparable company.

2. A Modified Scorecard Approach

This approach is somewhat similar but resembles the Berkus method. We use the same six dimensions but assign a predefined maximum valuation cap for a hypothetical “10/10” company. If a company scores a 10 in every category, it would be valued at this maximum valuation. The score for each dimension is then weighted, normalized and multiplied by the maximum valuation cap.

Conclusion

The scorecard method provides a structured approach to startup valuations, offering a way to break down the valuation process into clear components. However, scoring companies across dimensions is highly subjective and the challenge of finding reliable comparable data or setting a maximum valuation are inherent limitations in these methods. Additionally, the choice of parameters and the selection of comparable companies play a crucial role in determining the final valuation, making it important to handle these aspects with care.

Governance-Based Approach: The Dilution Method

The Dilution Method is a straightforward, governance-driven approach to determining a company’s value. This method primarily revolves around how much equity a founding team should be diluted during a funding round. While simple, it carries specific assumptions and limitations.

How the Dilution Method Works

The Dilution Method begins by identifying the funding need for the current round. This should be done by the company or during discussions with investors. Typically, the funding round should bring the company to the next significant milestone (e.g. PoC, product launch, etc) and should constitute a value inflection point. We advise companies to aim for 18–24 months of extra runway. Once the required funding amount is determined, the method estimates the valuation by focusing on the equity dilution that the founding team (and existing shareholders) is willing to accept during the round.

For example, it is common for seed-stage startups to see around 20% dilution. For later rounds like Series A or B, dilution percentages tend to decrease slightly as the company grows, typically ranging from 10% to 20%. For detailed number, see the following graph.

By applying this percentage, one can obtain an estimate of the startup’s valuation:

The pre-money valuation would then be calculated by subtracting the round size from the post-money valuation.

The Governance Focus of the Dilution Method

Unlike valuation methods that are based on financial forecasts or market multiples, the Dilution Method is purely governance-based. It centers around how much control and equity stake the founding team is willing to give up during a funding round. This approach recognizes that founders need to retain a certain level of equity to stay incentivized and maintain leadership, while also preparing for future funding rounds where additional dilution will occur.

The key assumption here is that dilution must be managed over multiple rounds. If the founding team gives up too much equity early on, they may lose control of the company in subsequent rounds. Therefore, the method seeks to strike a balance between raising sufficient capital now while preserving enough equity for future rounds of investment.

Limitations of the Dilution Method

While the Dilution Method provides a simple and governance-oriented way to determine startup valuation, it has several limitations that make it less reliable than more traditional approaches like the VC method or comparable company analysis.

1. Assumes Future Rounds: The Dilution Method assumes that the company will raise further rounds of funding. This may not always be the case, especially if the business reaches profitability or secures enough capital to become self-sustaining. In such cases, the dilution estimates may not be relevant.

2. Doesn’t Account for Specific Future Funding Needs: One of the method’s biggest shortcomings is that it doesn’t consider the specific funding required over the company’s lifecycle. For example, if a company raised a large Seed round, fully develops its product during this stage and enters the market, it should dilute more during the Seed round, since this is where the investment is de-risked. The company should then dilute less during the following rounds.

3. Inflates Company Value Based on High Round Size: Because the method relies heavily on the round size, a large funding requirement can lead to an artificially inflated valuation. The approach does not consider whether the funding need is justified by the company’s actual financials or growth potential. As a result, startups with higher capital needs may appear more valuable than they actually are, simply because they’re raising larger rounds.

4. Ignores Fundamental Business Metrics: Unlike methods that rely on future cash flows, revenue multiples, or earnings, the Dilution Method does not consider any underlying business fundamentals. It is based purely on the mechanics of how much equity the founders are willing to give up, which may not accurately reflect the company’s actual worth.

Conclusion

The Dilution Method is a useful tool for quickly estimating startup valuations, particularly in early-stage rounds where governance considerations play a significant role. However, it should be used with caution and in conjunction with other valuation methods that take into account the company’s financial health, market opportunity, and future funding needs. While easy to apply, the Dilution Method can lead to unrealistic valuations and does not provide a complete picture of a company’s long-term prospects. As with any valuation approach, understanding its assumptions and limitations is crucial to making informed investment decisions.