What is my company worth? How startup valuations are determined

When purchasing a product, we might consider the cost of creating and marketing the product. With art or collectibles, perhaps we compare to similar products. Perhaps we have an emotional or philosophical reason to make a purchase, in which case, price may be less of a consideration. But how do investors think about a startup’s valuation when they are acquiring a minority interest?

There are traditional ways to value companies. If you took economics classes in school, remember discounted cash flows (or “DCF”) analysis? DCF analysis attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future. Some investors, such as Steve Finn of Siddhi Capital, rely heavily on DCF: “With early-stage companies, DCF is everything,” Finn told us.

But for other investors, valuing a company is more of an artistic process.

Why does valuation matter?

Valuation has a huge impact on the rate of dilution on founder interests in a company.

Let’s say a founder owns 100% of the company, but then raises $1 million at a $10 million post-money valuation. (Pre-money valuation is how much the company is worth, or the value of a company’s equity before any investment of capital into the startup. Post-money valuation is how much a startup is worth after the investment capital is added to the company’s valuation.)

The investors will collectively receive 10% of the company and the founder’s relative percentage will drop to approximately 90%. However, if the same company raises that $1 million at a $5 million post-money valuation, the same investors will receive 20% of the company and the founder’s relative percentage will drop to 80%. The founder has the same number of shares they had before and the company receives the same amount of money, but the founder’s relationship to the whole drops significantly when the post-money valuation is decreased.

How do the experts determine valuation?

As many startups are not yet profitable at the point when early-stage investors are investing — indeed many startups are pre-revenue at that point — calculating a valuation is not always simply crunching the numbers. As a result, founders and investors have to use several methods for determining valuation, and experience in the industry helps with accuracy.

For Brett Topche of Red and Blue Ventures, valuation often comes down to company stage, industry trends and founder team experience. As a general rule of thumb, he said, valuations of pre-launch companies “tend to be in the single digits.” The founder team also plays a critical role for Topche when he is evaluating an investment: “If you have really experienced founders that have had success in the past, it often drives the multiple up.”

On the other hand, “if you have a greener team, that might result in a lower valuation,” he said. Round size and founder dilution can also drive valuation because it impacts management incentives.

“Ultimately you want to make sure that the management team owns enough of the company to [stay] incentivized to do the hard work of running the company,” Topche said. “Once it becomes just a job everything else is toast, so most investors want to make sure there is some fair and reasonable balance.”

One investor from an early stage venture capital firm noted that she often focuses “on companies that have a clear path to profitability and are capital efficient. Founders that are focused on getting to profitability (and can get there if they had to) will be able to demand higher valuations as will those that can show encouraging growth statistics.”

Finn said after applying DCF to their analysis of a startup’s valuation, Siddhi Capital has to consider how much “risk” is involved in the investment.

“How much runway does the company have? Will they run out of cash before achieving objectives? It’s not all about multiples — the valuation is also driven by how much the raise de-risks the company,” Finn said. “If the company only has 60 days of runway, then we might view that as too risky to invest because no round is closing in 60 days.”

Finn said the founder also plays a huge role in Siddhi Capital’s assessment of any company: “If the founder is THE person to take [the issue] on, then it is harder to pass on that.”

Greg Seltzer, a partner at Ballard Spahr, deals with valuation discussions on a daily basis with his clients on both the founder and investor side of the aisle.

“One would think that valuations are based on financial performance, projections and financial statements,” Seltzer said. “However, early-stage valuations are more determined by the industry in which the company transacts, market trends and comps.”

Variation due to industry and market conditions

Not only are there myriad methods for determining valuation, but valuation can be greatly impacted by external factors, too. That includes industry barriers, like thorny regulatory landscapes, and market conditions.

Valuation can be highly industry- and even product-specific. In 2022, the median early-stage VC valuation for biotech and pharma companies was $63 million, according to PitchBook’s 2022 US VC Valuations Reports. Enterprise tech, on the other hand, saw median valuations of $51.8 million in the same period, and consumer tech was even lower at $46.2 million. The reason for these industry variations, as Finn explained, “has to do with what it will take to achieve milestones. Life science companies need more money to get through regulatory approvals.” In consumer packaged goods, regulatory approvals and R&D are often less expensive hurdles to entry. “We see a lot of $10 million valuations in [consumer packaged goods], and then we see a lot of $20 million in food tech” — but Finn also noted that nothing is a guarantee and each company has to be able to substantiate its valuation even at the early stages.

Market conditions similarly impact startup valuations. In times of economic downturn — even if the economic downturn is merely perception — startups often see a cooling effect on valuations. For example, the average valuation step-up for public exits in 2021 was 1.55x, but fell to 1.05x in 2022. Topche is seeing much lower valuations at the later stages, and while the early-stage valuations have fallen a bit, this is mostly due to lower valuations at the very high end of the spectrum.

“The median hasn’t moved much, but the top has come down, so the mean has decreased,” Topche said.

In cooling off periods, founders (especially late-stage founders) may have to deal with the disappointing effects of a “down round,” which may include unexpected dilution for earlier investors and demoralization. Ultimately VCs are financing startups because they believe that they will get a return on an exit, generally through an IPO or an M&A transaction. If a startup is in the later stages of its lifecycle (post-Series D), the company’s valuation and possible exit opportunities become more connected. When exit markets slow, there is often a corresponding drop in financing valuation for later-stage companies because investors become concerned about their near-term liquidity opportunities, according to PitchBook-NVCA Venture Monitor, Q4 2022.

However, down rounds do not necessarily mean a company is doing poorly. One of the reasons Finn thinks that there have been more down rounds is simply that companies were raising at unsubstantiated valuations in 2020 and 2021.

“The ones that raised too much money are now scrambling to realign their cost structure to the size business that they actually are,” Finn said. “In the tech world, for example … they have had to retract and are being forced to identify their focus and cut the fringes.”

Seltzer echoed Finn’s sentiments and encouraged founders to “model the dilution of a down round so they can make informed decisions as we can often structure around significant founder dilution.”

When thinking about down rounds, founders should also be thoughtful about the caps they are setting in a SAFE or convertible note. While the cap in a SAFE or note is not per se the company’s valuation, many investors think of them as analogues. Topche, for example, “generally won’t do a [SAFE or note] deal at a cap above [where I] would be comfortable investing” if it were a priced round. So while it may be tempting to set an extremely high cap in a pre-seed round, “some of the emotional and motivational [implications of a down round are] still there if you are raising at a number below the cap” in your priced round.

2023 outlook

On average, valuations did see a decline over 2022 across all startup stages, with Series B valuations taking the hardest hit at a 20.8% decrease in total valuation between Q3 and Q4 2022, per AngelList and Silicon Valley Bank’s 2022 State of U.S. Early Stage Venture and Startups report.

“I hear everywhere that VC has all the dry powder in the world,” Finn said, “but VC firms need to tap LPs in order to deploy capital and we are trying not to when LPs are retreating due to market conditions.”

On the other hand, 2022 was still a banner year for startup valuations. Valuations for 2022 outperformed 2021 by a large margin. The median deal valuation for a seed financing in 2022 was $10.5 million, a significant uptick from the median in 2021, which was $9 million. Series B valuations also grew by 9.7% between 2021 and 2022.

“For young companies, valuations are going to stay steady, and perhaps increase, over the next year,” Seltzer said. “I have seen most money from VCs flowing into early stage due to upstream company growth stagnation.”

“Great [companies] are still raising capital at good valuations,” Finn said.

Others are cautioning entrepreneurs. Said another early-stage investor: “2023 is wild and will likely continue to be unpredictable — founders should be shoring up funds, watching cash, and avoiding risky initiatives as investors sort through where they will prioritize funding between portfolio companies and new investments.”

In initial negotiations with investors, “don’t spook the market,” Topche said. “I have seen people come out with very aggressive asks that stop negotiations before things start going. In the early days of a conversation, a low valuation isn’t going to make the conversation continue, but a high valuation will end it.”

Ultimately, valuations are negotiable. While investors may use formulas to determine valuations, there is no formula to spit out the perfect number because there are external factors and risk that are variable. If you are unsure where to start, Topche said, “look to your lawyers to get a sense of where the market is.”

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Kim’s Korner is a series of articles by Ballard Spahr’s emerging company and venture capital attorneys. The column is not legal advice. The substance of the column is derived from our experience working with founders and details many of the current critical issues facing startups.

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