5 things investors consider when valuing startups

Venture capitalists often think about valuations in two distinct buckets: pre- and post-investment. The former is typically more art than science, with early-stage VCs generally acting as price takers of a largely pre-determined valuation set by the company.

Occasionally, for investors leading a new priced equity round for an early-stage company, the setting of a pre-money valuation can be a collaborative process between founders and investors. But even in this scenario, valuation is typically the output of an informal formula whose variables include target dilution in the round and amount raised versus more fundamental valuation methodologies. The percentage dilution taken in the round informally captures an investor’s view of the competitive stature of the company, which can be influenced by the founder’s historical track record, perceived technological advantage, size of the TAM, potential competitors, etc.

It isn’t until a company progresses into later stages that investors begin using more fundamentals-based valuation methodologies, such as market approach valuations using public market comparables and precedent transactions, or even income approaches for companies with a credible path to positive free cash flow over the medium term.

In post-investment valuations, a process typically performed by fund support functions like finance, accounting, and operations, determining fair value is more science than art. Most industry-leading valuation guides encourage funds to calibrate valuations to the last priced equity round and adjust assumptions up or down based on factors like subsequent company performance, broader market dynamics, and perceived likelihood of an exit event like an IPO or acquisition. 

Let’s take a look at some of the considerations investors make when valuing a startup across stages: 

1. Dilution is often a primary driver in the early-stage

There are multiple ways investors think about setting valuation in a priced equity round, but generally, in the early-stage, VC investors are price takers of a largely pre-determined valuation set by the company. The pre-money valuation typically targets dilution in the round by weighing competitive dynamics such as founder track record, technological advantage, size of the TAM, potential competitors, etc.

According to Aumni Market Insights data, it is typical for Seed and Series A companies to take on dilution of ~19% and ~18%, respectively (see images below). The data shows that, on average, another 10% of dilution in Seed rounds is incurred due to the convertible components of previously issued notes, SAFEs, or other fundraising instruments. 

This level of dilution is often seen as a necessary trade-off for securing the capital needed to fuel growth and development. Investors must balance maintaining a significant equity stake to drive their own returns with providing the company enough resources to succeed. 

2. Downside protection through liquidation preference

Investors seek to protect their investments through mechanisms like liquidation preferences, which ensure that preferred stakeholders receive their initial investment back before any proceeds are distributed to common shareholders in the event of a liquidation or sale. This downside protection is crucial for investors, as it mitigates risk and provides a safety net in uncertain market conditions. 

Liquidation preferences can vary in structure, with some offering a simple return of the initial investment, while others may include a multiplier on the initial investment or participation rights that allow investors to share in the proceeds alongside common holders. These terms are often negotiated during the investment process and can significantly impact the overall valuation and attractiveness of a deal. For investors, understanding the nuances of these protections is essential for assessing the potential risks and rewards of an investment. 

3. For later-stage companies, fundamentals start to come into play

As startups mature and reach later stages, such as Series B and beyond, financial metrics become more critical in determining valuations. By this time, investors may have a broader perspective on performance and valuation benchmarks, allowing them to play a more significant role in setting valuations.

Key performance indicators (KPIs) like annual recurring revenue (ARR), customer count, and bookings are commonly tracked for earlier-stage companies. As companies progress, valuations become more company-specific, influenced by factors such as potential exit strategies and benchmarking against public market comparables or precedent transactions. This shift towards fundamentals reflects the increasing importance of demonstrating sustainable growth and profitability as companies approach potential exit events.

Investors also consider the company's competitive position within its industry, assessing factors such as market share, customer retention rates, and the scalability of its business model. These considerations help investors gauge the company's long-term potential and its ability to withstand competitive pressures. As a result, later-stage valuations often involve more complex financial modeling and analysis, requiring a deep understanding of the company's operations and market dynamics.

4. Other approaches (Rule of 40, Rule of X, growth-adjusted fundamental multiples)

For later-stage companies with more complex metrics, investors may use unique approaches to assess value: 

• Rule of 40: This metric balances growth and profitability, often used to evaluate the health of SaaS companies. It suggests that a company's combined growth rate and profit margin should exceed 40%. This rule provides a quick snapshot of a company's capital efficiency, helping investors assess whether the company is effectively balancing investment in growth with profitability.
• Rule of X (originated by Bessemer Venture Partners): Similar to Rule of 40, the Rule of X contemplates a company’s growth and profit margin but applies a growth multiplier to account for the fact that public company valuation tends to assign a premium for higher growth, reflecting the compounding positive impact of growth vs. the linear impact of higher margins. More on this approach here.
• Growth-adjusted multiples: For companies experiencing hyperbolic growth, adjusting traditional valuation multiples (like EV to sales or EV to gross profit) for growth can provide a more accurate comparison of valuations. This approach helps investors account for the impact of rapid growth on a company's financial metrics, ensuring that valuations reflect the company's true potential.
  

Investors also consider the various capital efficiency metrics like payback period or lifetime value over customer acquisition cost (LTV/CAC), which help assess how quickly a company can recoup its investment and how effectively it uses capital to generate returns. These metrics provide insight into the company's operational efficiency and its ability to generate value from its investments.

5. Considerations for pre-revenue/first-of-a-kind companies

For companies that don’t yet produce revenue and aren’t expected to produce revenue in the near or medium term, valuations are often based on milestones and the achievement of those milestones. This is common in sectors like biotechnology, where companies pursue clinical approvals, or in first-of-a-kind (FOAK) deployments of new technologies in climate or frontier tech.

In these cases, investors focus on the company’s progress towards key milestones, such as regulatory approvals, product development, and strategic partnerships. These serve as indicators of the company’s potential to achieve commercial success and generate future revenue. Investors also consider the company’s intellectual property portfolio, assessing the strength and breadth of its patents and other proprietary assets.

Understanding these considerations is crucial for startups and investors alike, as they provide a comprehensive framework for assessing a company’s potential and making informed investment decisions. By considering factors such as dilution, downside protection, and unique valuation approaches, investors can better navigate the complexities of valuing startups. 

Learn more about how Aumni can help your firm assess valuations with confidence.