Valuation is the process of determining the current or future value of a business. There is no single method for calculating valuation, but most approaches draw on factors such as a company’s management team, capital structure, and future earnings potential.
Recent valuations do not always indicate what the market is willing to pay for the business either in the present or the future. That is because unforeseen events such as a pandemic or an outstandingly good quarter can raise or depress fair value in minutes.
Validation is a wholly different process from valuation. Its objective is to understand whether a startup idea is likely to have traction in its target market. The process of validation usually begins by testing a prototype of a product or service on potential customers. Based on customer feedback, the prototype is then iterated, in other words, adjusted and hopefully improved, in order to see whether it increases customer uptake and retention. Positive data and feedback are often used to form the basis of a case study that can then be deployed to persuade more customers to give the product a try.
In the context of startups, both validation and valuation are concerned about the potential for revenue growth. Validation tries to verify whether growth potential exists in a chosen market, usually before the product or service is launched. Valuation normally comes after validation has taken place. It attempts to put a monetary value on that growth potential using revenue projections, which is what an investor’s return on investment (ROI) depends upon. Clearly, these projections gain more credibility when there is real-world data that demonstrate significant market traction.
Technology startup valuations are important because future growth is a deciding factor in securing investment. An angel investor who is looking for a good deal, which is to say an attractive ROI, will look closely at valuations in order to get a sense of whether a company is overvalued or undervalued in the marketplace. Business angels will also pay close attention to how the valuation is calculated.
Analysts often start the valuation process by looking at so-called fundamentals such as dividends, cash flow and growth rate. These can be said to reflect the health of a business in itself. But an investor naturally wants to know how the startup’s performance compares to other businesses in the sector. These comparisons are made using mathematical ratios and multiples such as price-to-earnings.
How a valuation is calculated depends on the specifics of an industry. In manufacturing, for example, assets such as machinery or factories will give an indication of fair value, which is what a buyer is willing to pay a seller assuming both parties enter the transaction willingly. But a technology startup doesn’t normally have any assets, apart from maybe some laptops. In this case, an investor will get a much better insight into potential ROI by looking at growth projections and earnings potential, otherwise known as intrinsic value. Intrinsic value is what discounted cash flow (DCF) valuations seek to capture.
Startups are notoriously difficult to put valuations on. If the startup is trialing an innovative idea that by definition has few precedents, then modeling growth and earnings becomes a challenge. In the absence of sufficient data or directly comparable businesses, DCF relies instead on estimates of future cash flows in order to determine the present value of an investment.
DCF helps an investor weigh the up-front cost of making an acquisition against the cash that the purchase can be expected to generate in the future. A positive DFC number points to a positive ROI while taking into account the average cost of capital, which is normally the prevailing interest rate. This is what the word discounted refers to.
The main drawback of the discount method is that estimations of future cash flows are frequently inaccurate, either because the model being used is not a good match for the business, or because circumstances on the ground have changed in an unexpected way.
Validating a startup
Most startup ideas are meant to solve a problem that people will pay for. Validation tests whether that assumption is true. The process begins by researching whether the market for your product is big enough, and what trends the market is experiencing. You also need to identify your product’s differentiator and unique selling point (USP) that will mark it out as better than the competition. It is also worth analysing previous startup failures in the same space, so that you can avoid repeating their errors.
While every good startup idea eventually needs to scale, at the outset you need a core version of your idea that can be implemented simply and quickly without spending scarce funds on hiring and automation. This enables you to test your hypothesis and build traction. The product doesn’t need to be perfect. By addressing the customer’s problem effectively enough to get paid, you can start to receive the feedback that will guide product iteration and improvement. Meantime you can develop the technology that will eventually automate various functions and facilitate scaling up. You may be able to presell the scalable version of the idea to your existing customers.
The valuation of a startup depends on the method of calculation, but also on perceptions of risk associated with the economy in which it operates. This is why a startup in the EU, the U.S. or Asia might receive a higher valuation than a similar one in a less economically and politically stable country such as Argentina. Validation is different from valuation. Here, the principles stay the same wherever your startup is located. Validation involves finding a scalable way to solve an urgent problem that a customer in your market will pay for, at a price that will drive revenue growth from the get-go.
If you’re seeking funding, guidance and support for your early-stage start-up, get in touch with the Pitchdrive team today to get started.