Startup Life/Funding/Analysis/ How do startup valuations actually work? Enterprise value is at the forefront of everyone’s minds right now. But how exactly does valuing a startup work? And what happens when the market is in turmoil? By Amy O'Brien 13 December 2022 Nik Storonsky Nik Storonsky \Startup Life Don’t count SPACs out yet, European dealmakers say By Selin Bucak 21 December 2022 Startup Life/Funding/Analysis/ How do startup valuations actually work? Enterprise value is at the forefront of everyone’s minds right now. But how exactly does valuing a startup work? And what happens when the market is in turmoil? By Amy O'Brien 13 December 2022 It’s the golden question for any company: how much is your business worth? While the value of publicly traded companies fluctuates from day to day with their share price, privately held startup price tags are less fluid. They’re negotiated by investors at each fundraising round, which may not happen every year, or even every few years. But like public valuations, private tech valuations are also at risk when economic or business conditions worsen, and we’re beginning to see the first signs of the public tech stock slump trickle down to private startups in Europe. So how exactly do investors arrive at the valuations they give startups? How have startup valuations changed in the current environment? And is valuation the be-all and end-all for founders? What do pre-money and post-money valuation mean? A startup’s valuation determines how much money anyone with a stake in the company — whether that’s an investor, founder or equity-holding employee — will reap on exit. VCs refer to valuations in terms of pre and post-money. Pre-money startup valuations are the estimated value of a company before the new investment is taken into account. Post-money is comprised of the pre-money valuation with the new investment amount added. For example, Very Clever Capital wants to invest $5m into SuperStartup based on a $10m pre-money valuation. The post-money valuation is $15m — equal to SuperStartup’s pre-money valuation plus Very Clever’s fresh $5m capital injection. What VCs consider when valuing a startup Investors say they consider a wide range of factors when pricing startups, and that their methods mainly depend on what stage in the startup lifecycle a company has reached. “Valuation, particularly at the early stage of investing at seed and Series A rounds, can be more of an art than a science,” Kilian Pender, partner at Northzone, tells Sifted. “Then it becomes increasingly about the financial metrics as the company progresses in its journey.” Seed and Series A: when people matter more At seed and Series A, where a company may be pre-revenue generating or working out its product-market fit, investors say they concentrate more on the quality of the founding and management teams. Characteristics they look out for are: Strong work background. Evidence of founding teams having worked at strong existing startups, corporates, consulting firms, banking or other industries which are difficult to get into. Impressive academic background. Evidence that the founding team has strong insights into the specific vertical which they are tackling. So, for example, has the founding team of an AI startup been working in the sector for a long time? A founder (or founding team) that has a strong vision for what they want to build. “It’s always impressive when founders have a good idea of how the world could look if the product they want to build is successful,” Pender says. Series A+: When financial metrics matter more Later on, when companies are revenue-generating, investors double down on financial metrics. These include: Revenue multiples — often used as an initial guide, as revenue is often the most stable metric for loss-making startups. Calculated solely on the basis of revenue, a startup that is growing at 30% to 40% a year, for example, might be given a valuation of 6x to 10x its annual revenue. The Customer Lifetime Value to Customer Acquisition Cost ratio (LTV/CAC) — pegs the lifetime value that can be gained from a customer against the cost of acquiring that customer. Payback periods — the length of time it will take a company to recoup the costs of investing in their business — whether by launching a new product, entering a new geography or hiring more people — with the money earned from that investment. Retention rates — the ratio of customers that stay with a company vs the risk of losing them (turnover). Product usage rate — measures how often and how much customers use the product. Growth rate — how fast a company’s revenue is growing annually. This tends to be higher at the beginning of a startup’s lifecycle. Is revenue recurring? — investors will analyse whether they think a portion of a startup’s revenue is likely to remain stable and predictable in the future. Company margins —although profitability is rare in startupland, investors will scrutinise whether the distance between the costs to run a business and the amount of revenue it brings in will narrow or keep growing as it scales. What are the revenue multiples like for competitors? Could the company’s market share be threatened? — how many other startups claim to be doing what this one is doing? Could they steal this startup’s customers, and therefore revenue? Are there newer entrants? How much capital have competitors raised? Investors typically expect lower returns on later-stage investments. “At the early stage, we might be aiming for 10x+ on our returns, but later on, we might be looking for more like 3x to 5x returns, depending on the risk stage of the investment and the risk of the sector,” says Pender. Future value Investors also make calculations based on forecasts and estimations for how much a company would be worth at an eventual exit — ie. its IPO value or cost to acquire. For VC firm Eight Roads, which invests at Series A and B, the main consideration when it comes to a startup’s valuation is a forecast of how valuable it thinks a company will be in 10 years’ time (the average lifecycle of a VC fund). “So the question becomes what valuation we can pay today to make an interesting return for our fund in that period,” says Virginia Bassano, an investor at Eight Roads. “Obviously, factors such as the quality of the team or how cutting edge the technology is can make a significant difference. But in the end, it’s also a triangulation between the size of the round, a palatable dilution for existing stakeholders and what a VC is willing to offer.” Market sentiment Investors will also be thinking about the prevailing market sentiment towards a particular product or sector. They’ll benchmark against how a company’s public counterparts are currently trading, while also factoring in how that sector may weather the economic conditions of the next few years. In the current environment, for example, due to inflation increasing and consumer spending decreasing, some consumer-facing startups will see their valuations beginning to be dragged down. Itxaso del Palacio, partner at Notion “Valuations are usually set by the market,” Itxaso del Palacio, partner at VC firm Notion, tells Sifted. “We look at both the opportunity of the business we are evaluating and the market conditions to define the value.” In late 2022, the sectors that VCs are shying away from investing in so much are those that are most exposed to declining consumer spend, rising interest rates or reliance on the health of other small businesses. According to Atomico’s State of European tech report, startups in the retail and consumer sector have seen their overall capital invested drop 48% in 2022 compared to last year. Specific verticals that VCs tell Sifted they’re avoiding include speedy grocery delivery; buy now, pay later fintechs; and riskier unsecured lending methods like revenue-based financing. Where are startup valuations now? It takes a while for slumps in public tech stocks to reach private startup valuations, and the trend weighs on later-stage companies first — as they’re closer to an exit. Every investor Sifted spoke to agreed that valuations were over-inflated in 2021 and that we’ll see a “correction” over the next year as startups begin to run out of cash. So far, the latest valuation data from Pitchbook shows that valuations have held up at the seed stage but begun to fall materially at later-stage rounds. In 2021, the average late-stage (classed as Series C, D or later) pre-money valuation in Europe was €237.8m, up from an average €83.4m in 2020, according to Pitchbook data. As of the end of the third quarter in 2022, this average had begun to slide down to €220.5m. But at seed stage, valuations in 2022 are even higher than in 2021, reaching an average €10.7m as of the end of the third quarter, up from an average €8.26m last year. There is always a bit of a lag in funding data, and the investors that Sifted spoke to suggest that things could now be dropping faster at later stages. That often leads to what the VC industry refers to as a “downround” — when a startup raises fresh capital at a discounted valuation from before. So far, we’ve seen only a handful of downrounds in Europe — but each one is indicative of the market sentiment we mentioned earlier. Klarna kicked things off in July when it tapped investors for $800m funding in a round that wiped 85% off its valuation, as we head into a period of rising interest rates and declining consumer spend. Elsewhere, payments startup SumUp raised €590m from investors in June at a valuation of €8bn, which was less than half the €20bn price tag it had reportedly set out to achieve. These repricings all boil down to the availability of cold hard cash. Most startups have a higher burn rate than revenue, which means they rely on investors for runway. As the recession deepens, investors tell Sifted we can expect to see more downrounds. “There’s going to be a good chunk of them coming over the next couple of years — but if you need the cash, you just need to get on with it,” Rob Moffat, partner at Balderton, says. There’s also another hack for tapping existing investors for more cash without marking your valuation down externally: a “flat round”. This is a funding round where the valuation is kept the same as that which a startup reached at its last financing round, and Mike Turner, partner at law firm Latham & Watkins, says they’re becoming more common. “They keep a flat valuation that’s based on something that happened 18 months ago, which is generally a better outcome for everyone,” he says. Valuations at exit Valuation also, of course, becomes important when a company is looking to buy another company. Last week, speedy grocery delivery startup Getir finally closed a deal to buy rival Gorillas that values the combined entity at $10bn, with Getir at $8.8bn and Gorillas at $1.2bn. This is a drop from the latest individual valuations they’d been given (of $11.8bn for Getir in March and $3bn for Gorillas last September), which reflects a tumultuous year for the speedy grocery industry after it slumped in popularity from its 2021 pandemic highs. What else do you need to consider as a founder when it comes to startup valuations? It’s important for founders to remember that valuation isn’t everything. Although a new $1bn price tag makes for a flashy headline, it’s the nitty gritty details in the terms of a fundraising deal that have the biggest impact on their business going forward. “I would always consider valuation as only one aspect of a deal, to be considered together with the terms, who is going to sit on your board and what kind of help the VC would provide,” Bassano from Eight Roads says. Virginia Bassano, investor at Eight Roads If they’re going to fundraise over the next few months, investors say founders need to scrutinise the other terms of the investment like the liquidation preferences and anti-dilution protection that can have a big impact on their company in the future — and may be compromised as the market wobbles. They’ll also need to consider the option pool and incentivisation of their teams when considering raising funds, especially if that’s at a lower valuation than before. That’s because when a company goes through a downround, it tends to harm the founders and early employees of startups more than it does their investors. They hold ordinary shares that will simply lose value, while current shareholders (ie. the investors) are more likely to take advantage of anti-dilution protection on their shares, which means that when a new round is issued at a lower price, they simply get more shares to make up for it. Founders also need to be prepared for tough times ahead. “The bar is much higher than it was last year, so as a founder, I would expect to have to speak to more funds, raise less, and recognise that valuations will be much lower compared with last year,” Pender from Northzone says. Where founders have supportive investors on their cap tables, Turner has seen quite a few examples of investors taking a bit more off the table so that they can “re-up” the founders with more shares (at the expense of their own), to incentivise them to continue working hard when times are tough. He points out that if you have good investors on your cap table, they will look after you in tricky times, and that your company valuation is one of the least important factors right now. “The crucial thing is you’ve got the cash to run and grow your business to get to the next stage — that way, the market will tell you whether you’ve got a good business or not in 12 to 18 months’ time.” Which startups boast Europe’s highest valuations? After Klarna was knocked off the top spot as Europe’s most valuable startup in July, Checkout.com wore the crown for five months at the $40bn valuation it hit in a $1bn fundraise in January. This round was a paragon of the 2021 funding “hangover”, and represented a massive 166% uplift on the $15bn price tag it scored a year earlier. But when compared to rivals Adyen and Stripe, its valuation didn’t really stack up today. In November, the payment giant’s own internal valuation was cut to $11bn, the same month that CEO and founder Guillaume Pousaz said he doesn’t actually care about the value of the company. That leaves Revolut as Europe’s most valuable startup, with a $33bn price tag. CEO Nik Storonsky recently told Sifted that the neobank will hit profitability in its annual results this year, which are due to be published later this month. If Revolut reaches that milestone, investors will have more of a reason to hold on to its current valuation. But its price tag is still higher than incumbent rivals like Lloyds Bank (£31bn), Barclays (£25bn) and Natwest (£30bn), and other UK HQ’d neobank competitors like Monzo ($4.5bn) and Starling (£1.5bn). Amy O’Brien is Sifted’s fintech reporter. She tweets from @Amy_EOBrien and writes our fintech newsletter — you can sign up here. Related Articles Six bootstrapped startups that have (so far) shied away from VC By Mimi Billing Click here to read more How to apply to the Future Fund By Amy Lewin Click here to read more What is startup fundraising really like for an ethnic minority founder in 2022? By Naomi Ackerman Click here to read more Future Fund releases first set of diversity data By Amy Lewin Click here to read more Most Read 1 \Healthtech Is Daniel Ek’s new body scanner worth the hype? Sifted tried it out 2 \Venture Capital VC diversity needs to change — and white men need to take responsibility 3 \Venture Capital New €3.75bn European Investment Fund pot to back late-stage VCs 4 \Sustainability Counteract closes £15m fund for carbon removal solutions 5 \Mobility Was the $5bn that VCs plugged into escooters worth it?