Early-phase companies often lack capital, which hinders them from realizing their business ideas and which makes them look for external funding.
When negotiating an investment offer, the key point is to agree on the equity offered in exchange for the invested capital, consequently, on the valuation of the company (e.g. if the founder offers 10% stake in his company in exchange for an investment of USD 2 million, it represents a post-money company value of USD 20 million).
Difference between startup valuation and mature business valuation
The valuation of mature businesses is based on the past earnings of the company. On the contrary, early-phase companies can usually show only future forecasts, which are much more complicated to assess.
Moreover, early-phase companies are immature and their innovative business model is usually unvalidated, hence the realization of the business plan is rather uncertain. That is why we have to use estimations when valuing a startup company.
There is no standardized framework for valuing a startup company, one can chose from various valuation methods. Every business venture operates in a different model and represents a variety of values, which all shall be taken into account in the course of company valuation.
This blogpost describes methods to determine the intrinsic value of the startup based on quantifiable elements. However, the actual investment deal is determined by the market. We shall always begin by looking up how much investors paid for companies of similar stage and business model.
What determines a startup value?
Factors that typically increase startup value
- Hotness of industry – startups entering a booming market will be very likely favoured by investors. A growing market expands the opportunities.
- Demand and supply, market conditions – soaring markets increase the willingness to invest, hence startuppers have a higher chance to receive an investment during an upturn. The valuation is affected by the supply of capital, too. If the aggregated investible capital exceeds the funds that business owners seek, it is easier to raise funds.
- Reputation – if the founders and business owners have great professional reputation, investors will trust in the success of the founder’s next venture more. Reputation is built up by past performance, strong personal and online presence, and it motivates investors to invest quickly and to be flexible about the terms of investment.
- Traction – any progress that the company and the founders can present. For early-phase companies even little revenues are important, but also user reviews, the number of subscribers and their growth, strategic partnerships, or even awards and certificates show great progress.
- Prototype – it can serve as a proof of the viability of the business. A prototype shows that the business concept is well-conceived and more mature than a sheer idea, which generates trust among investors.
- Existing revenues – if the company has entered the market and receives revenues, it verifies market demand and the viability of the business.
- Business model, distribution channels – it is particularly important to find a strong distribution channel, through which we can sell our products or services. This increases the business potential of the company and thus its valuation, too. In an early phase the business-to-consumer (B2C) model might seem expensive, therefore investors usually pick companies with a business-to-business (B2B) model. However, a large customer base can be attracted by a crowdfunding campaign of a company with B2C model.
- Strong online presence – a large and active follower base increases the chances of successful market entry or a successful crowdfunding campaign. Many users and customers may convert to investors and vice versa.
- Competent team – a company is suitable for investment if it can validate and realize the business plan. Investors have to be convinced thereof, otherwise they will consider the startup a sheer idea and not a business venture. Investors often invest in people, rather than the business idea. They have to be convinced that the team possesses the necessary skills and is dedicated develop a successful company.
Factors that typically reduce startup value
- Poor industry – if investors do not see the potential for growth on the given market, they will not finance new entrants.
- Fierce competition, low barrier to entry – if there are many players on the market and the competition is fierce, one has to come up with a particularly innovative business idea in order to receive investment.
- Low margins – if the company can sell its product only with low margins, it means limited earnings and thus limited return for investors, and increases the risks.
- Management not up to scratch – startups often fail because the management does not have a strategic approach and a sound business concept or key positions are missing. Therefore the most important aspect for many investors is to trust the team and believe they will realize the business plan.
- Product – if the product does not work or does not seem to be attractive, it deteriorates the business prospects and the value of the company.
- Desperation – it calls for caution if the business owner is seeking investment because the company is close to running out of cash.
The second part of our blogpost introduces the most popular startup valuation methods, presenting the opportunities they provide as well as the difficulties of applying these methods.