Business valuation dramatically reduces investment uncertainty. It is still a science under development as markets change and more information becomes available. Since valuations are forward-looking, the practice still involves a high degree of judgement.
Startup valuation is based on leading practices rather than set standards. Most early-stage valuation decisions take place during negotiations, nevertheless they are still based on implicit valuation know-how.
Early-stage businesses can be very different from one another. Startups are typically defined as companies with a scalable business model, focusing on a fast growth rather than profits, often technology-based. Another effective way to define them is through their financing story: startups rely on multiple rounds of funding to grow, aiming at a high and short-term exit or IPO. In fact, the transaction defines the valuation methods to be used. Whether a company fits into this description will depend on the startup story.
MUST STARTUP VALUATIONS BE DIFFERENT?
Startups have little to no past financials to account for to predict the future, and the failure rate is high, but this applies to normal businesses during the early phases as well. There are many more reasons why valuations in these circumstances need a different approach.
Added uncertainty of startups:
- New business models have no reliable data on possible future exits and likely fundraising paths
- Very successful startups may even create new markets that disrupt older business models, therefore changing underlying market assumptions
- Exit timing and multiples are fast changing as technology trends change fast in the startup market.
The practice of startup negotiations, financing and portfolios:
- There is a gap in expectations between what founders may promise or think they can achieve, and the probability that these expectations will materialise, and this gap in expectations is usually known and accepted by the investor
- The portfolio strategy and structure of VC funds, which invest early and rely on long-term exits, requires large winners to achieve a satisfactory return on the fund, as the very high risk afflicting the majority of early-stage companies needs to be balanced with a very high return, making normal businesses unsuitable for VC funding and leading many founders to overinflate their possibilities to fit into this model, or to create a strategy that purposely fits into this model
- Multiple rounds of funding lead to a high dilution of early investors
- These fundraising transactions often have very particular rights and clauses attached, sometimes with different rights held among different investors, which are not reflected in the valuation
- The only liquidity event, from which an investor can earn a return, is an exit, and therefore no return is earned from dividends in the typical shareholding contract
- Since an exit is a must, the conditions to enable a successful exit are usually planned from early-on, including a favourable shareholding structure
- The valuation scope, as it relates to a venture capital or similar round of funding, are different from other transactions, as multiple rounds, sometimes very close to one another, are expected. Also, the VC investor has a strong role in facilitating future rounds of funding, by introducing the startup to industry experts, and pushing for a fast growth and exit, which differ sometimes from the typical practices of private equity investors.
Budgets and asymmetric information:
- At the same time, available budgets to outsource valuations to experts are low, and a strong weight is placed on negotiations, which often also see the founders as having little negotiating power during the early-stages
- This links up to the fact that founders without extensive entrepreneurship experience may be unaware or not take into consideration how someone may turn a complex fast-growing company into a profitable one, or how investors achieve returns in startup companies, with more asymmetric information held by the two main negotiating parties.
DIFFERENT VALUATION ASSUMPTIONS