How does an investor arrive at a valuation for your company?

Discover how investors evaluate startups using methods like Discounted Cash Flow, Venture Capital, Berkus, and Balanced Scorecard. Learn what impacts valuation at different stages of your startup's lifecycle.

Picture this: You’re an early-stage startup looking for your first investor. You think you have everything in place—a viable product, some dedicated customers, maybe even a few friends and family backing your idea. Yet, you don’t have a clue about what your startup is worth.

This uncertainty around valuation is not uncommon, especially in today’s shifting market landscape, where trends like declining startup valuations are reshaping the investment ecosystem. According to a recent report by Nasscom and Bain & Company, the average valuation of Indian startups declined by 48% in the first half of 2023.

At the same time, this has been a record year for late-stage startups as several startups took their businesses to the public markets in comparison to any other point in history. So, naturally, this begs the question: How does an investor evaluate the potential growth of your business and arrive at a valuation that justifies it? At WeWork Labs we took it upon ourselves to simplify the technicalities so you can get some insight into the various methods investors use to understand your business, even before you enter a VC’s office to get that first check.

Discounted cashflow method

Generally common among private equity investors, the discounted cash flow method is a way through which a startup is evaluated based on its cash flow. To determine the potential value of a business, an investor would consider your future forecast cash flows and then apply a discount rate.

For instance, if your business is making $10 today, it may make $15 in the next month and so and so forth. What the DCF method does is it applies a discount to the potential cash flows and determines the value. The cumulative value of these discounted cash flows then gives the investor an outlook into the potential value of your business. What’s unique to DCF is also that it looks particularly free cash flow—which is cash flow after paying debt holders and equity holders. Using cash is also a stricter measure to assess business potential than profit, since profit also includes cash and non-cash components.

Note to remember: The higher the discount rate, the riskier the investment — and the better your growth rate needs to be.

Also read: Common mistakes to avoid by start-up founders

First Chicago / Venture Capital method

This method, commonly used by early-stage venture capitalists and private equity investors focused on early-stage ventures, combines discounted cash flow analysis with multiples-based valuation. In essence, it evaluates a company’s value across different scenarios to provide a more comprehensive assessment.

For example, if your company is worth $100 today, this approach considers three possible scenarios: an upside case, representing the best-case scenario based on strong growth projections; a base case, reflecting the most likely outcome for the company; and a downside case, accounting for potential challenges and unfavorable market conditions.

Once this is done, the investor would then also take into consideration discounted cash flows, a terminal value calculation (which is an exit price for the investor based on each of the mentioned scenarios), and probability weighting which is the value of your startup in each scenario multiple by its estimated probability.

This method is ideal for startups that do not have a consistent cash flow or are very early on, which is why it's a preferred method for most venture capitalists.

Note to remember: This type of method is ideal for startups in the early stage who do not have a defined cash flow or product.

Berkus method

Also a method commonly used by venture capitalists, the Berkus method is very similar to the previous method. The major difference between these two is that the Berkus method assigns weightage to a company’s value based on five major factors—Sound idea, Prototype of Progress, Team Quality, Strategic Relationships and Product Rollout or Sales. Based on how a startup fares in each factor, the total valuation of a startup can rack up $2 million in valuation. The caveats to this range though, include specific situations or specific industries.

Note to remember: This type of method is great for companies that do not have significant financial data.

Balance Scorecard

This method also uses a benchmarking approach to understand how a company’s valuation is arrived at. Broadly speaking, these are the factors taken into consideration:
Financial Perspective: Focuses on traditional financial metrics like revenue growth, profitability, and cost management.

Customer Perspective: Measures customer satisfaction, retention, and market share.

Internal Processes Perspective: Evaluates operational efficiency, innovation, and process improvement.

Learning and Growth Perspective: Assesses the organization’s capacity to innovate, improve, and grow, including employee training, organizational culture, and technological advancements.

For startups that operate in sectors without tangible assets this method is particularly useful. The Balance Scorecard ensures that all critical aspects of the business are captured, complementing traditional financial valuation methods. It is often used for more mature businesses or those in sectors where intangible assets (like intellectual property or customer relationships) are key. For early-stage startups, this method is less common but still valuable in assessing overall business health and potential.