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Startup valuation can be done for a variety of reasons, including raising capital, providing incentive stocks, one of the shareholders quits, mergers and acquisitions, entering public markets, and so on. In this article, we have tried to first evaluate the purpose of startup valuation, and then to examine the key points in valuation that are considered by financial institutions.
In fact, in this article we are looking to say: In general, what is the purpose of startup valuation, and why should you, as a founder or a venture capital expert, be familiar with the startup valuation literature?
- How do the industry and the market in which the business operates affect the valuation of startups?
- How much do the maturity of a startup affect its valuation?
- What are the common ways to value startups?
The purpose of business valuation
Startup valuation can be done for a variety of reasons, the most important of which are:
- Capital Increase
As you know, startups in different stages of their lives are constantly developing the product and developing their market, and therefore in most years of their lives, they have a negative cash flow. One way to counteract a negative cash flow of startups is to raise capital. In such a case, both startup founders and venture capitalists – in other words, both parties of the negotiation – need to know that the company’s required capital is equal to what percentage of the company’s stock, which will be helped by valuing the startup.
- Allocating incentive stocks to employees
There is no doubt that good ideas will not succeed in big markets unless a specialized and motivated team is focused on them. Finding elite people for various key positions in a startup and small business is not possible only with high salary offers, and it will not, as much as it should, motivate managers. That’s why most businesses always consider a percentage of their stock to offer to their top executives, in addition to their salaries, in order to form a long-term relationship with them. In such a case, it is necessary for the founders of the business to know the value of each share of the company, to design a proposal for their managers and other employees, and this is only possible by valuing the startup and small business.
- One business shareholder withdrawal
Startup shareholders may, for several reasons, decide to opt out of the stock mix and sell their shares. Sometimes the path of cooperation between the shareholder who wants to sell their share and other business shareholders nears a dead end, sometimes the life of the venture capital fund may be over and its shareholder may be forced to sell their assets; Or for any other reason. In such a case also, startup valuation is important and it is necessary to calculate the value of each share of the company. However, it should be noted that, in general, the value of a share that is calculated in startup valuation is different from the value of a share which is based on the price, the company’s shares are sold.
- Merger and acquisition
One of the shareholders’ exit windows from the combination of startup stocks, is mergers and acquisitions (M&A). In any model of agreement, for example, a business acquire a startup, or the two companies merge with each other in the form of exchange of shares or cash, and so on, the valuation of the startup must be done and the value of the shares of one of the companies or Both companies should be calculated and the merger and acquisition agreement should be designed and finalized based on it.
- Entering public markets or IPO
The most important exit window that startups look at and, which have occurred less in our country, is the issue of entering the stock market. In such a case, as it seems obvious, it is necessary to value the business and determine the value of each share of the company accurately and based on it, the initial public offering is done.
Will the market in which the business operates affect the valuation of the startup?
We should say very briefly, yes, one hundred percent sure. One of the key criteria for evaluating and, of course, valuing a startup is the market and the industry in which it is operating. Market research can affect the valuation of a startup in many ways, the most important of which are:
• Available market size
It is one of the key factors in market analysis of startups and not only influences startup valuation, but it is also a key criterion in screening and scrutiny of startups. In terms of startup valuation, however, this key factor has been very influential in methods such as scorecards and it is practically one of the key criteria for determining the relative value of a startup compared to similar startups and businesses. In short, the larger the market size of the startup, the more opportunities there are for the business, and the potential value of the business at the end of its life cycle or its Terminal Value will increase.
- Competition in the target market
Another parameter that influences the valuation of startups is the competition intensity that exists in the market the business is working in. How much is the market share of each of the other businesses in the market, how much of a startup’s capital is needed to be spent on advertising and marketing, is the ocean red or blue? It should be noted that the competitive environment has a direct impact on the different methods of startups valuation, the aggregation of risk factors, and the method of scoring cards, and in the other methods based on cash flows directly affects financial forecasting and future cash flows of business and also indirectly, it will affect the valuation of startups.
Briefly, the less intense the competition in the target market is, the startup or small business will be able to gain a bigger market share by less capital and increase its value.
- Market financial ratios
One of the most widely used methods in startup valuation are methods based on income and profit multiplier. In these methods, the basic premise is that businesses in similar markets have similar financial behaviors, and financial ratios such as the enterprise value-to-revenue multiple (EV / R) or enterprise-value-to-EBITDA ratio (EV / EBITDA) can be used to value businesses. In brief, the market in which a startup is operating has a significant impact on the valuation of that business and, moreover, it also has a significant impact on the accurate evaluation of the plan by venture capitalists. But the question that can be asked here is how can you dictate the value of your startup to the market?
In other words, if the norm of valuing a startup as an example in the field of marketing technologies in the first stage (Round A) is 20 billion rials, is it possible to put a value of 30 billion rials on a similar startup in the same stage and in the same market and attract investment based on that? The answer is yes. It should be noted that market customization, financial ratios, and target market size are not the only factors considered by the team valuing the startup and many other factors such as business model, future risks, performance history, cash flows and most importantly the entrepreneurial team; All and all will affect the valuation of startups. So if a business has a disruptive business model, it’s natural to expect that its valuation will be different from that of other startups and similar businesses in that market. In addition to the main idea that can be innovative and disruptive, sometimes a startup or small business may make changes to its revenue model and generate creative revenue streams and perform better than the average market.
Under such circumstances, the financial forecasts presented to investors will reflect these creative strategies for product and market development in the form of numbers well.
Do the level of maturity and the stage of development affect the valuation of startups?
One of the most important risks considered by venture capitalists in the analysis and evaluation of startups is managerial and operational risks. It should be noted that only having creative and attractive ideas in a large market is not enough, and the most important thing for the growth and development of such a business with such a market and idea is to have a motivated, specialized and focused team that can implement that idea in the market. When the startups are at the beginning of their life and maturity cycle, they have bigger managerial and operational risks, and this will naturally affect their valuation.
In addition, when an innovative and creative business model is proposed for a market, getting to product-market fit and proving the effectiveness of such an idea takes time. That’s why startups at such a stage are somehow in their Valley of Death and are always involved in finding a solution to recover from the negative cash flows of their business, along with the complex process of product adaptation. Older businesses, however, have passed these stages, found the optimal entering channels for their customers, and identified their business growth levers, all of which will greatly increase the value of their business. Business maturity, on the other hand, will also have an impact on the valuation process, where cash flows begin to increase.
In fact, the more a startup grows, the bigger market share it is expected to reach, and, accordingly, more revenue will be gained for the business. As business revenue increases, if the business model is scalable, the cash flow of the business will become more positive with an exponential growth rate, and this will affect the valuation of the startup. So in short, in addition to being affected by the market and rivals, startup valuation is also affected by the maturity and development of the business, and in practice, choosing the right methods for valuing a startup will be highly dependent on these criteria.