Challenges in Startup Valuations
Startup valuations are challenging for many reasons. The risks involved in investing in a business with no proven track record are prominent. There is a low probability that the business will be highly valuable and there is a high probability that the businesses will be worth little to nothing. From a Harvard Business Review (HBR) study, it shows 95% of the startups can’t meet their projections. For investors 70% of the time they lose money, 20% of the time they make some money. How about those unicorns and big exits we hear from our neighrbours? A whopping 2% of the chance you will be landing those.
Each Startup is unique
Each startup is also unique. After all, they were built to solve an unfamiliar problem. The nature of the business engender another challenge to startup valuations…There are lack of or no comparable companies. So many startups create a projection that is often based on the founder’s subjective forecast. Unfortunately, the forecast is often incomplete as there is insufficient information on the company’s financial clarity, business operating models, and value proposition in the industry.
Startup Valuation methods
To compensate the unknown areas, valuators rely on multiple valuation methods and try to measure the pros and cons of each. Here are some of the methods often used to value a startup company:
- Discounted cash flow – as mentioned, the challenge in discounting cash flow is the quantification of discounting rate and growth rate. These assumptions are vital for the fundamental of a fair market valuation
- Scorecard method – in another article, we discussed How Venture Capitalist Value your Company. A method for investors to line up the opportunities by scores
- Cost-based method – if the company had invested in intellectual property (IP) this method is often used to provide the opportunity cost for the investor to create the same product
- Multiple method – for startup, this method relies on its user base and its customer lifetime value (CLV). Investors would measure the net benefit building the CLV vs buying it.
- Scenario-based method – the scenario-based method is a statistic model that based on the assumptions provided by the investors
Bottom line
When valuing a startup, make sure you understand the risks involved in the business. How can the company go from $1M revenue to $100M revenue? The fundamental assumption is that people must need and want the product and services provided for a sustainable period of time. Believing in the product itself is also not enough. As a valuator, you must also understand the people behind the products. The qualification of the management team. What milestones have been achieved? Challenge on the underlying assumptions and question the operating models and valuation methods. Make sure the forecasts are being discounted with a reasonable rate of discount. The management team might not have all the answers right now. But it is essential for the valuator to corroborate facts and make sure assumptions made are justified.