Some people think you can’t value a pre-revenue startup company, and they’re wrong. Just wrong. But other people think you can value a startup and then go about it all wrong—sometimes dooming the company to failure by valuing it either too high or too low.
Startup valuation is a strange economic phenomenon because the best valuation is one that does not disproportionately benefit either the founders or the investors.
Unlike selling a used car, where the highest price is always better for the seller, an excessively high startup valuation can get a company “out over its skis.” If the company doesn’t grow into that valuation before its next financing, follow-on investment may become impossible without engaging in the dreaded down round.
But valuing the company too low can be equally destructive. If founders sell too much equity at low valuations in the early rounds, they may later discover that they no longer have enough ownership—or enough “dry powder”—to attract management, employees, and future investors through multiple additional rounds of financing.
Watch Shark Tank for plenty of examples of this self-defeating negotiation tactic at work. Founders often focus on getting the highest possible valuation today without thinking about what that valuation means for the next three rounds.
Here are a few more ways not to value a startup.
The most basic is to claim that startups can’t be valued at all, and therefore you need to use a SAFE or similar instrument instead.
The argument goes something like this: Since we don’t know what the company is worth today, we’ll postpone the valuation until a future financing and give today’s investor either a discount to that future price or a valuation cap.
The “discount” is for losers.
Yes, the discount is typically around 20% off the next financing round, which sounds attractive until you actually examine the economics.
Companies commonly space financing rounds 12 to 24 months apart. During that time, a successful startup may increase in value by 50%, 100%, or considerably more. The early investor supplied the capital that helped the company hire people, build the product, win customers, obtain regulatory approvals, develop intellectual property, or otherwise reduce risk.
And what does that investor receive for taking the earlier and substantially greater risk?
A 20% discount on a valuation that may have doubled.
Suppose an investor puts money in when the company would reasonably have been valued at $5 million. Two years later, the company raises its next round at $10 million. With a 20% SAFE discount, the investor converts at an $8 million valuation-overpaying by $3 million!
In other words, the investor who took the greater risk and supplied the capital that helped create the additional value is effectively paying $8 million for something that was worth roughly $5 million when the investment was made.
That is not particularly compelling compensation for early-stage risk.
A 20% return over two years works out to roughly a 9.5% annualized return. That may sound fine in many asset classes, but it is nowhere near the return profile required in angel investing, where investors need occasional very large outcomes to offset the substantial percentage of companies that ultimately return little or nothing. To achieve 10x in five years, for example, an investment needs to compound at roughly 58% annually.
The other common SAFE mechanism is the valuation cap—the valuation above which the investor will not have to pay an incrementally higher price when the SAFE converts.
Ideally, the valuation cap should have some relationship to what a reasonable preferred-equity valuation would have been at the time the SAFE investment was made. That way, the investor is economically rewarded for investing when the company was smaller and riskier.
But then comes the strange argument that the valuation cap supposedly has nothing to do with valuation.
We hear that nobody really knows what the company is worth, so the cap can be high. Of course, if nobody knows what the company is worth, you could just as logically argue that the cap should be lower.
Then comes the inevitable finale: “The valuation doesn’t really matter anyway because this company is going to be a unicorn and we’re all going to get rich.”
I don’t think these people can hear themselves talk.
If the company really is going to become a unicorn, valuation matters more, not less.
If I have the opportunity to own 20% of a future billion-dollar company instead of 10%, that difference represents $100 million of value before accounting for future dilution. The bigger the ultimate outcome, the more important the entry price becomes.
Another good way not to value your startup is to ask your attorney or CPA what it should be worth.
There are certainly attorneys and CPAs who understand startup valuation, but valuation generally isn’t their job. Too often, someone simply suggests a number based on what they have recently seen in other transactions rather than developing a defensible valuation from the economics of the specific company.
Believe it or not, hiring a traditional valuation consultant and spending $5,000 to $15,000 on a formal valuation report may not solve the problem either.
Most traditional valuation professionals spend their careers valuing established businesses. Their methodologies may emphasize EBITDA multiples, assets, leases, contracts, historical cash flows, and other indicators that work very well for mature companies.
That’s useful if you’re buying or selling an established business, going through a divorce, planning an estate, or inheriting Uncle Bob’s manufacturing company.
But those methodologies frequently produce nonsensical results when applied to a pre-seed startup with little revenue, negative EBITDA, few tangible assets, and enormous potential future value.
Showing investors that you spent $10,000 on a beautifully bound report that doesn’t reflect how venture investors actually price risk may simply demonstrate that you are not going to be a particularly good steward of their investment dollars.
There are plenty of other ways not to value a pre-seed company.
Using a simple multiple of current revenue is usually meaningless because a pre-seed company either has no revenue or very little of it. Applying a mature-company revenue multiple can dramatically undervalue a company whose value lies primarily in future growth.
Adding a million dollars to the valuation for every patent is equally questionable. In many industries, patents are simply table stakes. A patent may ultimately be worth nearly nothing—or hundreds of millions of dollars. There is no universal “one patent equals one million dollars” rule.
And comparing your company to the latest AI startup that raised $100 million in its so-called “pre-seed” round doesn’t work either.
That isn’t a comparable company. It is another world.
Unless you are actually capable of raising $100 million from the same investors under similar circumstances, that transaction has very little to do with the valuation of your startup.
One of the most reliable ways to fail at valuing a startup is to ignore the exit strategy—or worse yet, not to have one.
A real exit strategy should identify the likely acquirers, acquisition rationale, timing, comparable transactions, expected future financial performance, and the milestones necessary to make the company attractive to those buyers. Our Exit Strategy Canvas includes at least six factors that founders should be considering.
Ultimately, the economic value of a startup investment comes from the risk-adjusted, discounted future cash flows that eventually come back to investors.
For venture investors, those cash flows usually arrive through an IPO, acquisition, secondary transaction, or one of several alternative liquidity mechanisms. The analysis also has to account for additional financing rounds and the dilution that occurs along the way.
The exit is therefore the ultimate reality check on valuation.
There is obviously nothing certain about a projected exit value five or ten years in the future. But building a thoughtful exit strategy provides a rational framework for asking the questions that matter:
What could this company realistically be worth?
How much additional capital will it require?
How much dilution will occur before exit?
What return could today’s investor receive if the company succeeds?
And does that potential return justify the extraordinary risk of investing at this stage?
Of course, exit analysis is not the only way to value a pre-seed or seed-stage company. There are several legitimate early-stage valuation methodologies, and the best approach is usually to use several of them together.
None will produce a scientifically precise answer.
But taken together, they can produce something much more useful: a reasonable and defensible valuation range that founders and investors can use as the basis for negotiation.
Ignoring all of those methods is a great way not to value your startup.
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