A Guide to Startup Valuation

A Guide to Startup Valuation

On December 10, 2020, when Airbnb opened at $146 per share on NASDAQ in its first day of trading, the company more than doubled the $68 share price set for its IPO—and more than doubled the valuation the company had set for its market debut in the process.

A similar instance occurred with insurance company Lemonade during its IPO last July, in which the company’s share price soared 139% higher than its opening price on the first day of trading alone.

And of course, there is the other side of the coin. In recent years several large companies, including Lyft, Uber and Peloton traded well below their opening share price shortly after their market debut.

These drastic share price changes were caused by a simple fact: the public valued the company differently than the investment banks who helped the companies set their share price for their IPO. So how are company valuations set, and how can there be such disagreement over what the value of a company is?

As an investor, it’s important to have a grasp of how company valuations are set because the valuation, at a glance, provides you with a critical piece of information: what is the value of the company you are investing in?

So let’s dive in.

What Is a Business Valuation?

A business valuation represents the worth of the entire company in dollars. As Investopedia points out, “valuations are used for a variety of reasons, including sale value, establishing partner ownership, [and] taxation.”

In the context of StartEngine, the company’s valuation plays an important role in fundraising. If a business wants to raise capital from investors, then they need to set a share price for that offering, and projecting the company’s current valuation can help the company determine the current share price for the business.

Business valuation—especially for early-stage startups—is considered by many to be a relative, and not an exact, science. Different valuation methods can lead to different valuations (more on those below).

A company’s valuation attempts to make a holistic assessment of the business, and the value of a company could be determined by looking at a combination of the many factors including:

• An analysis of the founders and company management
• The company’s future earnings projections
• The capital structure of the business
• The industry the business is operating in
• The market value of assets owned by the company
• A review of the company’s financial statements and cash flow
• The business’ intangible assets (such as their brand—“story stocks”, for example—or investments into software development).

Pre-Money & Post-Money Valuations

A company’s valuation can be set before or after a funding round. As you may have guessed, a pre-money valuation refers to the valuation of the company before the funding round, and a post-money valuation includes the value of the capital the company is raising.

As an investor, it’s important to know whether a given valuation is pre-money or post-money because the answer can affect how much of the company you would own at the close of the funding round.

For example, let’s say you invest $250,000 in a company valued at $1M. If that is a pre-money valuation, then you would own 20% of the company ($250,000 is 20% of $1,250,000), but if that $1M is a post-money valuation, then you would own 25% of the company ($250,000 is 25% of $1M).

In most instances, valuations listed on StartEngine are pre-money, but please refer to the offering documents related to that campaign for details on the valuation set for that specific offering.

Valuation Methods

As mentioned above, there is no best way to value a startup, and even professionals can disagree on what a specific company’s valuation should be and what the best method to calculate the valuation should be.

Below are some of the common valuation methods, with brief summaries explaining how they are calculated.

1. Market Capitalization: This is one of the simplest valuation methods. To calculate a company’s market cap, simply take the company’s current share price and multiply it by the total number of outstanding shares.
   
2. Times Revenue Method: This method looks at revenue generated over a certain period of time, typically quarterly or annually. A multiplier is then added to that figure to calculate its valuation. That multiplier can vary based on the economic environment as well as the industry the company is operating in (for example, a software business may see a higher multiplier than a retail business due to its better margins).
   
3. Discounted Cash Flow Method: This method is based on future cash flow projections, taking inflation into account to reach the company’s present value. In other words, this method tries to predict how much cash the company will generate in the future in order to determine its value today.
   
4. Market Multiple: This method values the company by comparing it to others. What acquisitions of similar companies occurred in the past year, and at what price? Then a base multiple is determined with those examples (for example, the base multiple could be 4X sales). This method gauges what the market is willing to pay and invest in—an important part of setting a valuation.
   
5. Cost-to-Duplicate: This method analyzes how much it would cost to recreate the company from scratch. For example, this method would calculate the cost of the physical assets owned by the company or the total development time required to rebuild their software.

Valuations Across Funding Rounds

An important thing to keep in mind with valuations is that they tend to change as companies raise additional funding rounds. In order to ground your understanding of valuations in context, let’s look at the median pre-money valuation of companies across different funding rounds in 2020 through Q3 (data taken from Cooley):

• Seed Funding: $9.3M
• Series A: $31.1M
• Series B: $107M
• Series C: $230.9M

Of course, these figures should not be taken as “fair” valuations for companies, but they can give you a rough benchmark of what to expect from different companies at different stages of funding.

Valuation Caps

On StartEngine, you may also come across opportunities to invest in companies and purchase convertible notes. On these campaign pages, you will see a valuation cap instead of a valuation. This value represents the maximum valuation your investment will convert into when the convertible notes “convert” into equity in the company. The lower the valuation cap, the larger percent of the company you will own when your investment converts.

Conclusion

Business valuations are often considered a relative science, and many would argue there is no such thing as an “objective” value for a company beyond what people are willing to pay for it at any given point in time. However, the methods mentioned above can help you understand how some startups and early-stage companies may have been valued, especially where the financial analysis for such early-stage business is often still limited by the lack of available data.