In simple terms, start-up valuation can be defined as the process of figuring out how much a company is worth. Early-stage investors make equity-based investments in startups in return for money.
In addition, knowing how much of the company’s stock an investor will receive as compensation for their seed-stage investment is skeptical.
As a result, startup valuation should be given special focus and roughly based on the valuation of other similar startups. This article imparts an understanding of the various challenges in startup valuation and provides clarifications.
Challenges Founder Face in Startup Valuation
The first step of a successful startup is determining the company’s value. For the most part, various assumptions are used to support the valuation as startups don’t have a history in the market.
The basic startup problem is that the accuracy of the valuation is directly related to how close those assumptions are to the actual outcome in the future. The real challenge founders face during valuation is briefed below.
Understand Start-Up Valuation
While a new business may have the potential to grow successfully, it still faces a lot of challenges. Many different sources of funding are required for startups so they can build a successful business from the ground up. That’s the reason why understanding startup valuation becomes vital.
Startups can use the actual revenue statements for valuation. However, when it comes to raising money, a company is only worth what the investors think it is worth.
A startup valuation is a process of determining the total value of a start-up company to foresee its future value in the market, most often done to pitch an investor in return for percentage equity in profit.
Startup valuations reveal a company’s ability to use the new capital to grow, meet consumer and shareholder expectations, and reach the next benchmark.
A startup valuation can take into account a variety of things, including the expertise of the team, product, resources, business concept, the total addressable market, competitors’ performance, the market opportunity, and goodwill.
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Why Do Founders Need Startup Valuation?
Calculating a company’s worth is more of a skill than a science. This is especially true when it comes to valuing startups that have little to no historical data to draw from. There are many reasons why startup valuation is necessary. Some of them are even essential to the future of the company. Here are a few of them:
To get funding from investors: Startup valuation highlights future potential. The investor needs to get a clear-cut idea of what they are investing and what they will receive in return. Startup valuation caters to that need. It’s hard to forecast startup revenue, but knowing your financial projections will help you evaluate your company and convince investors of your worth. Put yourself in the position of a potential investor to fully appreciate the significance of this step in the investment process. Boost their interest in investing in your startup rather than the hundreds of others they see throughout the year.
To set targets and realize risks: The founders of the company can understand and estimate the value of their company and set probable targets to achieve. It goes a long way in making the founders choose the right decisions for the company. As startups lack the reliability of past performance and predict future performance, valuation using methods and frameworks are significantly important.
To help make a broader plan: The estimations involved in a startup valuation come in real handy to create a plan for the future. When a startup is just getting started, it can raise as much money as possible at the highest possible valuation, and then use that money to help the company grow. If the startup is a success, its valuation will rise dramatically in the next round of funding, more than paying for the ‘Seed’ round of funding.
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Five Challenges Founders Face in Startup Valuation
Startup valuation is dependent on the functioning of the business or the environment in which the company operates on a number of different variables. It includes the company’s historical trend, prospects for development, managing experience, the company’s share of the market, the cycle of the economy, changes at the macro level, regulations, and policies of the government, etc.
When valuing a more mature or established company with data for analysis, they can take solace from the historical trend; however, such a trend/track record is not available when valuing “Start-ups”. And that is one of the major challenges founders face in startup valuation. Here is a list of common challenges in startup valuation that companies can be informed about:
No Revenue or Small Revenue:
Start-ups generally concentrate on establishing their business model, building a clientele, and finding customers for their products or services. The result is negative EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) because they generate very little or no revenue compared to the costs of business establishment.
A company’s business plan can become highly subjective due to an overly optimistic outlook. Valuers should address this risk by adjusting discounting factors for both the risk premium and the perpetual growth rate used to derive terminal value so that they can account for the possibility that the aggressive forecast will not be met.
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Hidden Costs in Forecasting:
There can be hidden costs, such as founders agreeing to take a salary or withdrawing a salary at a higher rate once a certain milestone is reached. Such hidden costs should be included in the business plan when applicable. As long as this milestone is not met in the forecasted time frame, it must be recalculated or taken into account if it has a relative multiple method impact.
When the company achieves a certain amount of topline, the royalty rate will rise. Even if this milestone isn’t reached in the projected time frame, the impact on royalty rates must be taken into account when calculating the terminal value (if using the DCF method) and the impact of lower EBITDA due to higher royalty rates must be considered (if using a relative method).
More than 1 Type of Share:
Seed funding, angel funding, and other forms of private investment are used by startups. The claims or rights attached to the shares issued at each round of investment can vary, and it may also include quasi-equity instruments such as CCDs or CCPs, or equity shares with differential rights.
It’s hard to figure out an investor’s percent ownership when there are so many different kinds of equity claims in place. To calculate diluted equity, the Valuer must understand the terms of each of these instruments and attempt to convert them to an equivalent number of equity shares.
Established companies have a higher liquidity premium, which means investors can get out of the investment faster without sacrificing value, so a premium for liquidity does not have to be added to the discounting factor but it’s not the same for startup companies.
Unless and until a start-up has a very promising business model and a proven track record, it is difficult to exit investments made in start-ups because of the lack of liquidity. A valuer in this situation would have to add a liquidity premium to the discounting factor as an additional return to investors for investing in illiquid companies.
Dependency of Key Personnel:
The majority of new businesses rely on just one or two key employees. A special talent or ability is one of the keys to a company’s long-term viability. As an example, a key person in a technology startup is the person who designed the software that the business relies on.
If this employee leaves the company for any reason, the company will be exposed to a two-fold risk. First, the company’s long-term viability is in jeopardy, and second, a key employee who has left the company could become a competitor.
Due to the obvious possibility of losing key personnel in these start-up companies, the Valuer must adjust the discounting factor by including a risk premium, which is an additional return for taking on the risk.
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How to Avoid Challenges in Startup Valuation?
While it’s understandable that valuing startups comes with a lot of uncertainty, look for ways how to overcome startup challenges. There’s no reason why startup companies can’t be valued systematically as established ones.
Here are a few things to be kept in mind. To make sure you do not bump into lots of challenges in your startup journey.
- Preparation is key for a conservative business valuation and a professional appraiser is recommended for this job. Even if you compare it to previous investment valuations, the amount could be remarkable. Most start-ups fail before the IPO. Many more businesses are merged or acquired, or they simply go out of business. Such an outcome will almost certainly be forecasted in startup company valuation.
- A startup business is always valued at a particular point in time. There is no guarantee that a company will be worth more in the future simply because it was worth more previously. It’s possible that your appraiser will point out impending headwinds or question your earnings or market share growth projections. As a result, your company may have a lower value than you anticipated.
- If the value of your start-up increases after it goes public, don’t automatically conclude that your private valuation from a year ago was incorrect. A publicly-traded company is worth more than a privately held company because of the open market. It’s because stock liquidity attracts a greater number of investors, driving up the stock price.
Apart from these, there are lots of things that can be learned through experience. As your journey commences and moves ahead, things will gradually become more clear.
Are You up for the Challenge?
As the business grows, the company’s earning projections will gain momentum. As a result, startups can be confident in the accuracy of their business valuation and other successful start-ups have a similar strategy.
Congratulate yourself if you are the proud founder of a prosperous start-up. Large public companies are likely to pay attention to successful start-ups with rapid growth. As a result, interest in investing in these startups grows, and their value rises.
Consult a professional valuer to delegate startup valuation through which you can forecast startup problems and solutions.