What’s a company worth?
For larger, more established businesses, answering this question is relatively simple. They have years of financial statements showing revenue and profit from which to estimate their value. Public companies that trade on stock exchanges have a market capitalization derived from their share price. In short, they have hard numbers to help determine their monetary value.
So what happens when a company doesn’t have this information? Startup valuation can be difficult to determine, especially if a company is early stage and pre-revenue. Yet a valuation is necessary if a company wants to raise cash from investors or lenders to grow. Fortunately, entrepreneurs can use various startup valuation methods that are designed for just this scenario.
What does startup valuation mean?
A startup valuation is an estimate of how much a startup company is potentially worth at a specific time. This estimate is based on multiple key factors, including its financial condition, market opportunity, growth potential, intellectual property, physical assets, and more.
Valuing startups is tricky—especially for early stage and pre-revenue startups that have yet to generate sales to use as a valuation basis. Several different valuation models exist, and the whole process is as much an art as a science.
Despite this fuzziness, it is critical for startups to determine a valuation if they hope to raise capital. Valuation helps dictate how much equity a company gives investors in exchange for their investment. A startup’s valuation can fluctuate over the course of multiple fundraising rounds.
Practical startup valuation methods
- Berkus method
- Comparable company analysis
- Scorecard valuation
- Book value
- Discounted cash flow
- First Chicago method
Each startup valuation method has pros and cons, and some are better suited to certain stages of a company’s life cycle. No single model is best. Entrepreneurs may determine valuation using one or a few of these methods:
1. Berkus method
Venture capitalist Dave Berkus developed this model in response to venture capital firms’ challenges in evaluating pre-revenue, early stage startups. The Berkus method has evolved over the years, but it remains focused on assigning dollar amounts to five critical characteristics. The method proposes adding up to $500,000 to company value for each of the following qualities (if the business has them):
-
A sound idea that creates basic brand value
-
A prototype, which reduces technology risk
-
A quality management team with a record of execution
-
Strategic relationships with partners and advisers
-
Product rollout or sales, which represent a smaller production risk
Of course, venture firms or other investors may have sound reasons to place a lower valuation range on each factor, but the Berkus method serves as a useful starting point.
2. Comparable company analysis
Also called “comparable transaction analysis” or “multiples analysis,” this valuation method is similar to using “comps” in real estate, where a home’s value is based on recent sale prices for similar houses in the area. The comparable company analysis sets a startup’s valuation based on the value of similar companies in the same industry and stage of maturity.
For example, if comparable businesses raised money at a valuation of four times their sales, that can serve as a starting point for your startup’s valuation. Note: You might adjust this sales multiple up or down depending on factors like your business’s age or the size of your customer base relative to these comparable companies.
3. Scorecard valuation
The scorecard valuation method starts with the average valuation of startups in the same industry and region as yours. To create a scorecard, identify important characteristics that contribute to startups’ success, and assign a percentage weight to each one. These details can differ, but a sample might look like: 30% team, 25% market opportunity, 15% product, 15% traction, and 15% risk.
For each characteristic, you’ll assign a percentage for your company’s success, with 0% indicating total failure and 100% indicating total success. Next, you’ll multiply each score by the corresponding weight, then multiply the product by the average valuation of comparable startups.
For example, say the average valuation of comparable startups is $10 million. If you've gained traction with customers but don’t have as large a user base as the comps, you might grade yourself at 80% for traction. For the traction category, you would calculate:
80% x 15% x $10 million = $1.2 million
Repeat for each category and add the results for your total valuation.
4. Book value
The book value method is straightforward: It equates your company’s net worth with its valuation. So your book value is your company’s total assets, minus any liabilities.
The data for this calculation comes from your balance sheet. First, add up the value of your physical assets, like equipment, property, and inventory (don’t forget to consider depreciation for some of these items); and intangible assets, which include software, licenses, patents, and proprietary technology. Subtract your liabilities, such as debts, loans, and mortgages.
Note that this method has limitations: Sometimes net worth is close to zero or negative, especially for startups with lots of debt and few assets. This isn’t necessarily a bad thing (depending on where you are in your journey), but it means you’ll likely be better served by a different valuation method.
5. Discounted cash flow
Discounted cash flow (DCF) is an income-based valuation method that determines your company’s value based on how much money it’s likely to generate in the future. The discounted cash flow method works well for newer businesses with high growth potential, but it also entails more risk for investors.
You’ll first project your future cash flows, then apply a discount to the valuation based on the expected rate of return on investment.
6. First Chicago method
This method expands on DCF, considering three scenarios for the company’s future performance: a best-case scenario in which you perform better than financial projections, a base case, and a worst case.
You’ll get three different business valuations via the DCF method this way. From there, you can assign a probability to each scenario based on how likely it is to happen, multiply this probability by each valuation, and then add all three products together to get a weighted-average valuation—one that takes into account a few possible future scenarios.
Tips for evaluating your startup
Determining your business valuation can be overwhelming. The process is demanding, and you’re emotionally invested as an entrepreneur who believes in your company’s worth. Here are a few practical tips to help:
Mix your methods
Each startup valuation method has pros and cons, and you may find that many investors have their favorites. Consider using multiple methods to determine your startup’s value. Taking a more comprehensive approach can help show potential investors that you can back up your initial valuation.
Quantify where you can
Investors want to see your startup’s traction and growth potential. If you have favorable sales data, highlight growth metrics like your revenue growth rate, repeat purchase rate, and customer retention rate. If you have little to no revenue yet, focus on achievements in product development, customer validation of your business model, and any other progress that shows your competitive advantage and potential.
Consider your company’s stage and broader market trends
Companies that are very early in their lifecycle are a bigger investment risk, so valuations tend to be smaller while investors’ equity expectations are larger. Keep your own expectations in check to determine a fair value; pre-revenue valuations simply aren’t as high as post-revenue valuations for companies with significant sales. Also, consider how broader market conditions—both the economic environment and how hot your sector is—may affect investors’ likelihood of spending money.
Startup valuation FAQ
How is the valuation of a startup calculated?
Startup valuation is both an art and a science, and there are several different models for calculating this value. Overall, the valuation is generally based on multiple characteristics, including the company’s financial performance, growth potential, assets, and more.
What is the best valuation method for a startup?
The reason several valuation methods exist is because no single model is best. Each method has pros and cons, and some may be better suited to earlier- or later-stage startups. Some of the best methods include the Berkus method, comparable company analysis, and the discounted cash flow method.
What are the top three valuation methods?
While there is no ranking of valuation methods, several popular models fall into a few general categories. Some valuation processes focus on comparing a company to other startups (like the comparable company analysis method and the scorecard valuation). Some center on a company’s assets (like the book value method) while others (like the discounted cash flow and First Chicago methods) focus on potential cash generation.
*Shopify Capital loans must be paid in full within a maximum of 18 months, and two minimum payments apply within the first two six-month periods. The actual duration may be less than 18 months based on sales.