A Guide to Startup Valuations
The terms “unicorn” and “decacorn” are synonymous with the tech industry. Besides being a fun way to recognize successful startups, both terms are also shorthand for a startup’s valuation. A unicorn means the company is valued at over $1B, while a decacorn is a startup that’s valued at over $10B.
A startup’s valuation underpins the entire fundraising negotiation process between founders and VCs. While founders and investors both want the startup to become a unicorn, investors also want to purchase a meaningful equity stake at a reasonable price-per-share. Invest at too high a valuation (i.e., overvalue the equity), and the business may never meet its lofty expectations—preventing you from seeing a meaningful return on your investment. But if you invest when the valuation is low and the startup exceeds expectations, you could see outsized returns.
As such, understanding how to value a startup—particularly an early-stage business without many financial indicators—is crucial to success as an angel investor. In this guide, we’ll go over the basics of startup valuations, including what they are, how they’re determined, and the ways VCs approach valuing a startup business.
To learn more about how startups are valued, consider joining Angel Squad—Hustle Fund’s cohort-based program for aspiring angel investors. Learn more >>>
What is a startup valuation?
A startup valuation is the financial value of a startup’s equity at a given point in time. Unlike public companies, where the stock is listed on an exchange and fluctuates throughout the day based on trading activity, private startup valuations are agreed upon by the investors and the founder(s) when the startup goes out to raise a round of financing.
This valuation is based on a variety of factors, such as the financial performance of the business, the background of the founders, the strength of the team, maturity of the business, competition in the market, macro market conditions, investor demand, and the founder’s fundraising goal. Founders will value their startup when raising capital, but VCs will also perform their own due diligence using the aforementioned factors to determine a valuation they’d feel comfortable investing at. The two sides may then negotiate an acceptable valuation for both parties.
Note, two different kinds of valuations are considered in most startup fundraising rounds: the pre-money valuation and the post-money valuation.
The pre-money valuation is the valuation of the business before it receives any outside investment. This is the number negotiated between founders and VCs that informs how much the investors’ will need to put in to purchase their desired equity stake (Hustle Fund's fund model does not require target ownership percentages in companies, but many other venture fund’s do).
For example, if a company has a pre-money valuation of $2M and I want to purchase a 20% equity stake, it means I’ll need to put in $500k ($500k / $2.5M = 20%).
The pre-money valuation is more art than science. Investors determine the pre-money using a variety of methods (which we’ll cover further down), but there’s often an element of subjectivity given early-stage businesses don’t have a lot of concrete data to base a valuation around.
Also note the pre-money valuation will usually change every time the startup goes out to raise a new round of financing. For instance, a seed-stage startup might raise at a $5M pre-money valuation. After 12-18 months of growth, it’ll return to raise its Series A at a $10M pre-money valuation. The increase in pre-money valuation would represent the additional value the startup has created by acquiring more customers, improving its product, building its brand, etc.
As the name suggests, the post-money valuation is the startup’s valuation after receiving outside investment. Unlike the pre-money valuation, the post-money valuation is easy to determine: simply add the investment amount to the pre-money valuation.
To return to the previous example, a startup that raises $500k at a $2M pre-money valuation is said to have a $2.5M post-money valuation ($2M + $500k = $2.5M). The post-money valuation is the total equity value the startup is believed to be worth at the present time. When a startup is referred to as a “unicorn,” what’s really being said is its post-money valuation exceeds $1B.
A startup on a good trajectory should see its post-money valuation increase with every new financing round (i.e., investors should view it as growing in value). If the post-money valuation goes down round-over-round, it’s called a down round, and could signal the business is in peril.
Aside from determining the total value of the business, investors use the post-money valuation to understand their ownership stake. You can divide the invested amount by the post-money valuation to understand how much of the business’s equity you own.
Amount Invested ÷ Post-Money Valuation = % of Ownership
Startup valuation methods
As we mentioned, determining the pre-money valuation of an early-stage startup is more art than science. Nonetheless, VCs use a variety of methods to try and hone in on a number that feels reasonable. Here are a few common startup valuation methods popular amongst VCs:
Venture capital method
The venture capital method is based on a determination of the anticipated selling price of a startup and what you expect the ROI to be. The expected selling price (also known as the “terminal value”) is typically based on estimated revenue multiples in a given sector or price-to-earnings ratio (i.e., current share price vs. per-share earnings).
Anticipated ROI = Terminal Value ÷ Post-Money Valuation
Post-Money Valuation = Terminal Value ÷ Anticipated ROI
A savvy investor wouldn’t pay more for a startup than it’d cost to duplicate the business. As such, the cost-to-duplicate method considers all of a startup’s tangible assets (product, materials, etc.) to determine how much it would cost to build the same exact company from scratch. The cost-to-duplicate method abstracts away subjectivity from a startup valuation by only considering historical expenses.
The big nitpick with this method is that it fails to consider a startup’s future potential or its intangible assets (e.g., brand equity). As such, the cost-to-duplicate method generally provides a valuation on the lower-end of the spectrum and may be one of several data points a VC uses when determining the valuation.
The comparables method (also known as the market multiple approach) bases the valuation on recent exits for similar companies in the market. This method informs VCs of how much the market is currently willing to pay for this type of business.
If, for example, a competitor business with 100k users was acquired for $5M, it’d mean each user was worth $50 to the business ($5M ÷ 100k = $50). If the business you’re valuing has 200k users, the comparables method would imply a valuation of $10M (200k x $50 = $10M). You can then adjust that valuation up or down to account for additional factors (e.g., stage of business, macro market conditions, etc.).
While the comparables method can come close to determining a “fair” valuation, it’s entirely dependent on there being another recently acquired business in the marketplace to base the valuation around. This is never a given, especially considering deal terms are often kept under wraps for a period of time after an exit is complete.
Discounted cash flow analysis
Whereas the cost-to-duplicate method discards a startup’s growth potential entirely, the discounted cash flow (DCF) method is based entirely on a business’s potential. To perform a DCF analysis, one must determine how much cash flow a business will produce in the future, and then apply an expected rate of investment return to calculate how much that cash flow is worth. The expected rate of return is known as the “discount rate.” Cash flows are discounted to account for the time value of money—a core financial principle based on the idea that $10 today is worth more than $10 at some point in the future.
For more details on how DCF, refer to this guide.
Valuation by stage
This method bases valuations around the idea that there’s a ballpark range of valuation for startups based on the maturity of the business. The more mature the business, the lower the risk, and the greater the valuation. For example, a seed-stage business may not have even brought a product to market yet, meaning the business is high-risk, which justifies a lower valuation.
When valuing VCs by stage, it helps to consult market data to understand how valuations change over time based on broader market conditions. AngelList’s Real-Time Valuation Dashboard tracks fluctuations in valuation across various growth stages. AngelList also creates an annual report with median, upper, and lower-bound valuations for startups on its platform. AngelList shared their 2022 valuation data with Hustle Fund:
A “rule of thumb” valuation method like this will vary by company and investor. Generally, it can be helpful to use this approach to determine a baseline before utilizing a more methodical approach to parse the specifics of the business.
Hustle Fund method
Along with these industry standard valuation methods, Hustle Fund also performs its own due diligence on a business based on the given valuation. Our guiding question is whether or not we believe the valuation can 50-100x based on a handful of inputs.
Inputs we consider include sector (we tend to focus on SaaS businesses vs. hardware businesses because it’s easier to see a path to exponential growth at high margins), public market comparisons, and revenue multiple. We factor these inputs into the current valuation, and then try to determine what the valuation could be if things go right for the businesses. If there’s, say, a viable path to $500M ARR, and we’re investing at a $10M post-money valuation, that’d be a 50x multiple from the point where we’re investing. In that situation, we’d aim to invest in the business.
Startup valuation vs. 409A valuation
A guide to startup valuations wouldn’t be complete without touching on 409A valuations. A 409A valuation is an appraisal of the fair market value of the common stock of a private company by an independent third party.
Startups need 409A valuations to be able to offer equity compensation to their employees (a valuable startup recruiting tool). The 409A valuation determines the price at which employees can purchase common stock—the portion of stock reserved for employees.
Often, 409A valuations will differ from venture valuations. This is due to a handful of factors, including the valuation methodology (409A valuations are determined by an independent third-party appraiser instead of would-be investors), class of stock (common stock is less valuable than the preferred stock VCs often receive), and compliance obligations (409A valuations need to hold up under IRS scrutiny).
Generally, the 409A valuation will be lower than the venture valuation—but the appraiser will consider a startup’s post-money valuation when determining the 409A valuation. To remain compliant and avoid tax penalties, startup’s typically update their 409A valuation annually, as well as with every new fundraising round.
Last word on startup valuations
Startup valuations (particularly pre-money valuations) are far from straightforward. However, if you’re an angel investor in a round with larger VCs, it’s important to note that you likely won’t have much input in the price-per-share anyway. Lead investors (i.e., the VCs putting in the most money) typically dictate the PPS that all other small checks abide by. Even still, it’s helpful to understand how VCs value startups to determine which deals are right for you.
Hustle Fund’s Angel Squad offers members deeper insight into the startup valuation process, including webinars detailing investment terms based on business performance. To learn more about Angel Squad, click here >>>