Key Factors of a Valuation for Startups: Tech Edition
So how can you derive the best possible value for your tech startup? There is a 1.28% chance of your startup becoming the next unicorn (value > £1bn), however, focussing on these 6 key factors will give you a strong value base ahead of your next financing round, so unicorn or not, capital raising can be based off a strong valuation and help propel you into growth.
Valuation for a Startup
Valuing an established business, although never straightforward, is possible using one of many recognised valuation methods for that sector/industry.
When a company is being valued, the most common methods used in investment banking are:
- Private equity (PE), mergers and acquisitions (M&A)
- Leveraged buyouts (LBO)
- Discounted by cash flow analysis (DCF)
- Comparable company analysis
- Precedent transactions
These methods rely on having a company’s financial accounts available, competitors operating in the same market and/or a history of competitor buyouts, mergers and public listings.
The valuation for a startup can be a trickier process. Often a startup has no financial history (and if they do it often shows no value and may be years away from showing sales), competitors or precedent transactions. In fact, sometimes a startup is even developing its own marketplace, so no information whatsoever can be derived from companies operating in a similar space.
There are some startups with astronomical valuations, such as ByteDance (£101bn), Stripe (£69bn) and SpaceX (£54bn). So how do investors formulate a valuation for a startup? A startup valuation can go far beyond the value of its component parts. Instead, additional startup value is derived from the synergies that exist between the resources, intellectual property, technology, brand and any financial assets at the startup’s disposal. Investors also see value in non-tangibles such as first-mover advantage. Below are some key factors to consider that will make sure your tech startup derives the best possible value.
1. A Strong Customer Base or Network of Users
No matter what market your tech startup operates in, even if you create your own market, there has to be a plan to derive revenue. Otherwise, there is nothing to invest in.
Even free to use tech services have their own diverse array of revenue models, be it advertising or otherwise, (think Facebook, Booking.com and Airbnb).
Consider Snapchat as an example:
“Snapchat can be downloaded to mobile devices free of charge. All of its features can be accessed for free, including by creating Snaps; conversing with family and friends; and finding friends' stories on the discover feature. These features are designed to drive user engagement, which in turn helps to attract advertisers and drive revenue from advertising”.
If your startup has no existing customer base or network that proves people need or use your product/service, you should have a firm plan of how to get there. Having a pool of loyal, returning users is a great starting point for revenue, even if your startup initially has none. From this, potential investors can visualise possible income streams (and ROI) and exit strategies.
Your startup may be the next unicorn and have an idea that can change the world, however, without someone to pay for all the work that goes into it, it may never get going in the first place.
It’s important to distinguish between driving revenue and posting profits. Investors in startups are comfortable making valuations based on future earnings potential. They may not expect companies to be profitable in 2, 5 or even 10 years’ time. Consider companies such as Peloton, Pinterest and Lyft, these companies as of 2021 have not recorded net profits, however, they attract huge valuations based on their ability to attract a large network of users and therefore revenues.
2. Growth Potential
When was your startup founded? Where in your journey are you now? How does that compare to your competitors?
Investors will want to ensure that your tech startup is ‘going places’, otherwise they may as well keep their money in the bank. Having a plan to scale up and achieve high growth shows investors that you’re in control of your destiny and have considered possible barriers and risks to your enterprise.
No plan can be perfect and the unexpected will always happen, but you should be able to show investors where you intend to be in 12 months, 2 years and 10 years’ time and how you intend to get there.
For a startup, attracting new investment is key to success, and in the world of venture capital ‘money follows money’. Being able to show investors how you plan to scale and achieve high growth for your startup is a sure fire way to bring them onboard with you. Once you have the confidence of one set of investors, others are more likely to follow them for fear of missing out on an opportunity.
A fundamental growth strategy should include:
Current Proposition: this should explain how your startup is unique and well placed to exceed the needs of the market.
Target Market: do you know who your customer base is? Have you analysed their trends and behaviours? You should have done enough research to be able to talk with confidence about your network and how your offer reaches them.
Indicators of Performance: understanding your market and company will help you choose the performance metrics that you can measure success on. These are important so that you can communicate and represent your progress effectively to investors.
Competitor Analysis: What is your competition doing? How does their offer differ from yours? Analysing your competition shows investors that you understand your market and will be well placed to pivot your plan should you need to.
Scaling: How will you use the money investors put forward? How much debt will you be taking on? Having a plan to scale is important so that investors can plan for ROI and exits, however, your plan should not be too risky and should be dynamic and not incur fixed costs that cannot be scaled back.
3. Making Profits
The end goal of a startup, besides becoming the next Apple or Amazon, is to become established in your market, increase revenue and post net profits. But how do you get there and more importantly, how do you convince early-stage investors of your ability to get there?
Investors see value in lots of different aspects of a startup. In essence, early investors are betting on the ability of your startup to return 20-30x their initial investment, based on the risk to such early-stage capital. As mentioned above, a large user network (and revenue potential) is a great place to start. But there are several steps to take between proving that a market exists to show that there is a potential to make a profit in that space.
Focussing on making a profit does not have to be the primary focus of your startup, as investors in businesses such as yours are complex and can see the potential in even the earliest stage ideas. In other words, they may not expect you to be profitable within the short or even medium term.
That said, being profitable, or focussing on becoming profitable, definitely has its upsides:
- It makes attracting investment easier (and on more favourable commercial terms), especially investors who may not want to be too involved and see the benefit of you being able to run a profitable business.
- It gives you more exit strategies, many companies making acquisitions will avoid unprofitable companies.
- It gives you a higher valuation for your startup.
- It gives you more flexibility when making strategic decisions as you move towards scaling and high growth. Being able to make decisions to invest money already in the business to drive growth helps keep costs down and provides founders with a greater return on exit.
4. The Value of Your Brand
Brand awareness is vital for a startup to gain traction in its marketplace. Standing out from the crowd or differentiating your offer from competitors can make a huge difference for a startup, and it doesn’t always need a huge PR budget to accomplish. Companies can build strong brand recall among its client base by word of mouth or viral advertising campaigns alone.
Every aspect of your tech startup makes a contribution to your brand. Everything from the font of your business emails and the way your employees dress and behave up to the core values and principles that your company is based on.
Once you embrace this idea of the whole company being a brand, you can use it to your advantage. This will help avoid the mistakes made by many founders, such as focussing too much on expensive marketing campaigns that sound like a good idea but gloss over the fact that your brand identity isn’t authentic or defining.
As a tech startup, you have an opportunity to build a strong brand identity, one that will help you find direction, make meaningful connections with your customer base and attract and retain talent. You should take time to develop an identity and outline what’s going to make your brand unique. Your business plan and market research can help here, things that make your offer stand out are the things you might want to incorporate into your brand, for example, if you aim to be “faster”. There are other ways to make your startup stand out, your brand might be less traditional than its competitors and may target a younger audience.
Taking this opportunity to develop a strong brand helps build value in your startup by adding customer awareness and engagement to your company.
5. Capital Investment
Attracting capital into your business can be vital to ensure your startup is a viable concern, but it should also be balanced against the needs of the company. The options open to early-stage startups can be limited, with friends and family often being an important source of funds. Beyond this are venture capital investors and then financial institutions. Each of which will have its own framework for making investments and its own goals for wanting returns on any investment. Focussing on the key factors in this article can give you a good foundation for your startup and open up new sources of funding, which gives you options as your business grows.
The people likely to invest in the early stages of a startup before the company is well established are venture capitalists. These are often people investing their own (or sometimes other people’s) money. Their aim will be to find opportunities in early-stage companies, operating in markets where the risk is reduced to an acceptable level. They will not invest in opportunities where the level of risk outweighs the probability that their return targets will be met.
Venture capital professionals look for opportunities that have the potential to produce large growth in business value in a short space of time. This type of lending is inherently high risk so successful investments have to provide big enough returns to offset all the investments that fail. Typically, venture capital funding will focus on innovation and emerging markets that can be projected to grow by large multiples. Venture capitalists may provide management help or expertise to the founders in return for capital investment.
Knowing the aims of investors during the early rounds of capital raising can give you a head start in attracting interest. By understanding the goals and the aspects of your business that will be of greatest interest to investors you can focus your decision making and time in making these areas as strong and resilient as possible. The first investment will typically be the hardest to attract and once you have won the backing of one or more investors, others are more likely to follow suit.
6. Market Conditions and Competitors
Valuing a start-up is a subjective process and relies on many unknown variables, opinions and factors. At this stage, the founders will be of great importance to investors and they are essentially being ‘weighed up’ to see if they are up to the task. With even the best team in place, a startup with even a strong competitive advantage will be challenged if the market conditions are not favourable.
If the market is crowded this can make gaining traction difficult for a new business, in this case, your business will have to stand out in some meaningful way. In order to become distinctive to customers in this case your offer must exceed the current needs of that market.
Crowded market conditions can be navigated by finding a niche that established businesses are currently overlooking. There are often opportunities in crowded market conditions that can generate meaningful revenue for a startup, and often these opportunities would not be worthwhile for other companies (with higher costs) to pursue. However, before targeting a niche area in a market, research has to be done to ensure that the opportunity can be scaled.
In a new or emerging market, the conditions are invariably favourable to the first movers. There may be risks associated with breaking new ground but the potential upside can be enormous, and once the market share is established it can be much easier to adapt and hold on to it than try and take it from someone else. If such conditions exist, investors will price this into the value of the startup.
Market research is essential and not just in terms of consumers, competitors too must be analysed and understood so that you can identify opportunities and mitigate risks. Competitive research comprises evaluating your competitor’s strengths and weaknesses and then assessing the strengths and weaknesses of how they operate and the products and services they provide. By analysing your competitors in such a way, you can take a view of how your products and services compare and their strengths and weaknesses. Competitor analysis also helps you identify the macro trends and behaviours that are influencing companies in your industry or economy.
Performing this research gives you an overview of the conditions that you will be operating in, which is imperative for a new business. It also gives you the knowledge and understanding to be able to make strategic decisions and be best placed to take advantage of business opportunities and competitor weaknesses. Building this information into your growth and brand strategies adds value to your startup and allows investors to understand your business and business plan on a fundamental level.
A valuation for a startup can be difficult, unpredictable and based on professionals outside of the startup and their previous knowledge and experiences. In order to maximise value, founders can focus on key elements of their business to ensure it is best placed to build revenue, leverage opportunity and mitigate risks, inherently adding value. Valuations may be based on the team; the potential size of the opportunity; the competitive environment; and the need for further financing later on. It is important to remember that when involved in valuing a startup, no valuation is permanent and no valuation is straightforward. This report has covered 6 key factors of a tech startup valuation. By considering these factors you will discover ways of adding value to your startup. This value process will allow you to understand your market, consumers and growth strategy and in turn, prove to investors that your business is worth investing in.
At the beginning of the exciting journey of a tech startup, it’s important to make the right decisions and get the right support. Check out our handy guides for more valuable startup tips.
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