How can a company with no product, no revenue, and five employees be worth $20 million? Meanwhile, a 50-year-old profitable manufacturing business might be worth only $5 million.
This isn't a mistake. It’s the fundamental difference between traditional valuation and startup valuation.
Simple Definition
Traditional valuation measures a company's present worth. It looks backward at historical profits, cash flow, and tangible assets (like factories and inventory) to determine value.
Tech startup valuation, by contrast, is an estimate of a company's future potential. It ignores the present (which is often $0) and instead focuses on the probability of capturing a massive future outcome. It's less about accounting and more about market dynamics.
Simple Example
Imagine valuing a popular local bakery. You’d look at its consistent annual profit of $200,000. A buyer might pay a "multiple" of that, say 5x, valuing the bakery at $1 million. Its value is tied to its proven, stable cash generation.
Now, imagine valuing an AI startup. It has $0 in revenue and is burning $100,000 a month. A traditional model values it at less than zero.
But a venture capitalist (VC) sees a world-class engineering team tackling a Total Addressable Market (TAM) worth $50 billion. If this startup can capture just 1% of that market, it could be a $500 million company. The VC invests $2 million for 10% of the company, implying a $20 million "post-money" valuation.
The VC isn't buying assets; they are buying a high-risk, high-reward "call option" on that future $500 million outcome.
Why It Matters
Understanding this difference is key to understanding the modern economy. Traditional valuation is retroactive; it relies on history. Startup valuation is predictive; it relies on forecasting growth, scalability, and market size.
A startup's value is not based on what it is but on what it could become.
This is why tech companies can raise millions before they have a single customer. Investors are funding the potentialfor exponential growth (scalability) in a huge market (TAM). A bakery can't easily 100x its revenue; a software platform can.
Practical Insight
Since profits don't exist, how is the "price" actually set? It’s a mix of art, science, and negotiation, often boiling down to three methods:
Comparables ("Comps"): This is the most common method at early stages. What did similar startups (same industry, same stage, similar team) raise money at? If five other "AI-powered sales tools" just raised $3 million at a $15 million valuation, that sets a strong baseline for the next one.
The VC Method: VCs work backward. They ask, "What could this company realistically sell for (exit) in 7–10 years?" Let's say $1 billion. To get the 20-50x return they need, they calculate what they can pay today to make that math work, heavily discounting for the extreme risk that it will likely fail.
Discounted Cash Flow (DCF): This is a traditional method adapted for startups. Instead of using past cash flows, you project highly speculative future cash flows (e.g., "Year 5 revenue: $100M") and then discount them back to today's value at a very high-risk rate (30-50%+). This is often more of a spreadsheet exercise to justify a number than a source of truth.
Ultimately, early-stage valuation is less a precise calculation and more a negotiated price set by market demand (how many VCs want in), team quality, market size (TAM), and traction (any early signs of product-market fit).
Quick Summary
Traditional valuation prices a company based on its past performance; startup valuation prices the probability of its future success.