Mastering Startup Valuation: Strategies and Pitfalls

Why value your business?

Valuing a business in the early stages means being able to gain a better understanding of its specific assets, which will form the basis for decisions on how much to reinvest into the business.

A common pitfall for startups transitioning to scale-ups is not productively and efficiently communicating with investors. Whether it's to seek financing, consider possible exit strategies, or deal with offers for the business, the more you know about your business, the less uncertainty you will face when making a decision, and that certainty comes from knowing the true value of your business. 

The main problem with valuing a business is the valuation is either too high or too low. If the valuation is too low, you may be at risk of giving the investor a bigger equity stake in your business; you might also either miss out on other investors or end up with the wrong kind of investor who doesn’t share your passion or vision. Alternatively, if the valuation is too high, you still risk ending up with the wrong kind of investor, or, you may distance other more apt investors.

So what methods can be used to make sure you are valuing your startup in the correct way?

Method of valuation	How does it work?	Drawbacks
Cost to duplicate	Calculating how much it would cost to build another company just like it from scratch.  The idea is an investor wouldn’t pay more than the cost of duplication.  Calculated by taking into account all costs and expenses involved.	This method doesn’t reflect the company’s future potential for generating sales, profits and return on investment, which are key selling points for many startups.
Market multiple	Valuing the company against recent acquisitions of similar companies in the market.  E.g. If computer software firms are selling for 3x the sales, you can use the 3x multiple for the basis of valuation.	It is not always easy to find companies that are close comparisons, particularly in the startup market.
Valuation by stage/ development stage valuation approach	Set by the investors themselves, the method involves using a rule of thumb value which determines where the company has progressed along the development pathway.	The rule of thumb values may be different for each investor and may not reflect the true value of each startup.
Net Asset Valuation	Calculated from the company balance sheet as assets - liabilities.  Looking at the potential to generate future profits and discounting values such as brand, team, relationships etc.  Usually divided by outstanding shares, to give a NAV on a per-share basis.	The value of start-ups lies in their potential for growth and future profitability. Determined by other factors that are “off-balance-sheet”, and which this method ignores.
Discounted Cash Flows	Typically based on a company’s Cash Flow Statement (showing cash flowing in and out of the business over a specific period).  A discount rate is applied for future cash flows, to convert them into their equivalent “Net-Present-Value”.	This can require confidence in the long-term prospects of the business, regarding the sources and amounts of cash predicted to flow in and out of the business over the coming years. As such, it may be less appropriate for startups compared to established businesses.
Industry Valuation Rules of Thumb	Any valuation method which considers the non-financial aspects of your business, that are relevant to a specific sector and capable of quantification. For instance, the number of retail outlets, or the number of customers.	Only certain sectors use “these rules of thumb”; typically those where businesses are frequently bought and sold.

Additionally, there are tools available for startups, which can be considered when securing an accurate valuation. Databases such as Crunchbase directly compare your valuation to similar businesses in order to compare whether targets are exceeding or whether the valuation is reasonable. 

Owner-Operator Dependency and transferring Goodwill

Often, the owner(s) of the business themselves may create a burden upon a company’s valuation. Owner-Operator Dependency is where the owner(s) are so embedded in the business and crucial to its success, that the business would be worth significantly less without them. A potential investor has to factor in the risk that you could one day decide to simply walk away from that company; taking all the benefits you personally bring to the business. The solution to this problem is to transfer personal goodwill into business goodwill for the various facets of your business:

Business Function	Personal Goodwill	Business Goodwill
Sales	Generated by personal contacts.	Generated by the reputation of the brand, location, and pricing.
Management	Decisions are based around the owner and/or their micromanagement.	Autonomous team can continue after the departure of the owner.
Marketing/ Advertising	Focus on the individual.	Focus on the brand.
Process	Not systemised; remains in the owner’s head.	Systemised, documented and transferred.
Agreements	Loose collection of agreements and personal relationships.	Formalised agreements between stakeholders and business.
Referrals	Generated via personal relationships and networks.	Driven by formal, commercial relationships.

It is important to consider which method best suits your startup, by considering the position and strengths of the business. As the various methods indicate, realising the value of a business is arguable and negotiable. Whatever method you decide to use to base the valuation of your startup, flexibility and justification will aid your development and progression.

- Authors: Edward Benett and Aminoor Masoom

- Authors: Edward Benett and Aminoor Masoom

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DISCLAIMER

This article has been written by law students for the sole purpose of providing informative insight. The information in this article is intended for educational purposes only and does not constitute legal advice. You should seek independent legal advice before relying on any of the information provided in this article.

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