How Do Startup Valuations Work When A Company Isn’t Profitable?

A startup can be worth millions, attract investment from some of the world’s biggest venture capital firms but somehow, still lose money every month. So, how is that possible? Surely a company needs to be making money in order to be worth anything?

Contrary to popular belief, in the startup world, valuation isn’t just about how much money a business makes today. It’s also got just as much to do with potential. That is, what investors believe it could become, how quickly it might grow and whether it can eventually turn that potential into profit.

Of course, that doesn’t mean that all startups making a loss are worth a fortune (or really anything at all). Thus, understanding how valuations work means looking beyond the obvious.

What Does A Startup Valuation Actually Measure?

A startup valuation is an estimate of what a company is worth at a particular point in time. For private startups, that figure is often established when investors agree to put money into the business in exchange for equity.

Unlike established companies, however, which can be assessed using years of financial results, younger startups may have limited revenue, little operating history or no profits at all. That doesn’t mean that they don’t have any value, it simply means we need to measure more than current funding. Thus, investors have to consider other indicators, including things like customer growth, market size, recurring revenue and the strength of the product.

For instance, you may have a software startup that’s losing money but rapidly signing up paying customers. If investors believe demand will continue growing and the company can eventually become profitable, they may be willing to pay a premium for a stake in the business, even though the company’s current valuation may not be particularly impressive.

Of course, potential isn’t the same as guaranteed success. A high valuation reflects expectations, not a promise that a company will deliver.

Why Would Investors Back A Loss-Making Startup?

For venture capital investors, the appeal here tends to lie in growth. Many technology businesses need to spend heavily before they can scale; they might invest in product development, hire engineers, expand into new markets or spend money acquiring new customers. These expenses can leave a startup unprofitable even while its business continues to grow.

Indeed, some investors are willing to accept short-term losses if they believe the company can eventually generate substantial returns.

Unsurprisingly, investors will still want evidence that the model can work. Strong revenue growth, customer retention and a credible path to profitability can help support a valuation. Unfortunately, simply spending money quickly and promising future success won’t necessarily cut it.

How Do Investors Calculate A Startup’s Value?

There isn’t one universal formula, especially for early-stage companies, as much as we may wat one. As a result, investors often combine several approaches:

• Revenue multiples: For startups with established sales, investors may compare their revenue with that of similar businesses. A company generating £5 million in annual recurring revenue might be valued at a multiple of that figure, depending on its growth, margins, retention and market conditions.
• Comparable companies: Investors look at valuations and transactions involving similar businesses. However, comparisons can be difficult when a startup operates in a new market or has a very different growth profile.
• Future potential: Investors also assess the size of the market, the company’s competitive position and its prospects for future cash flow. The earlier the business, the more uncertain these estimates become.

The result here is more of a judgement rather than an exact science. Two investors can look at the same startup and arrive at very different valuations, so it’s rather subjective, to say the least.

Does A Higher Valuation Mean A Startup Is More Successful?

That’s the thing that may be surprisng to most: an impressive valuation can be misleading because it doesn’t tell the whole story.

A startup valued at £100 million isn’t necessarily sitting on £100 million in cash. If an investor pays £10 million for a 10% stake, the implied post-money valuation is £100 million. That doesn’t mean the investor has bought the entire business at that price or that the company could be sold for the same amount.

Of course, as we all know, valuations can also fall. If growth slows, funding becomes harder to secure or investors lose confidence in the business model, a startup may have to accept a lower valuation in its next funding round.

Ultimately, a high valuation can give a startup access to capital and help it attract talent, but the other thing it does is it also raises expectations. Investors will eventually want to see a business capable of turning growth into sustainable returns.

Because while a startup doesn’t need to be immediately profitable in order to be considered valuable, it does need a convincing reason why it might be one day.