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How do you get potential investors to notice you in a crowded pool of startup investment opportunities? Developing a reliable valuation may be a good start, but this can be challenging for a startup company. Part of the problem is that startups don’t fit well into the traditional valuation framework commonly used by investment bankers, private equity groups, equity research analysis, or any other valuation professional. These groups depend upon the ability to make reasonable rationalizations for the valuations they present while marketing your startup.
Valuation professionals will utilize discounted cash flows and guideline multiples observed from comparable transactions and public companies to determine a valuation or to make a recommendation. But, startup owners may be frustrated when they are not able to achieve expected value when raising money in capital markets. Is there a solution?
Startup Valuation Challenges
Traditional income or cash-flow-based methodologies rely on forecasting a future benefit stream, which is an obvious challenge for a company that is pre-revenue or in very early stages of operations with an uncertain cost structure. Poor-quality projections limit the reliability of a forward-looking valuation approach causing investors to be more likely to question your startup’s asking price. During the valuation process, startups can expect questions like these:
- After several years of losses during the research and development phase of your startup, how are you going to immediately turn profitable next year?
- What are the drivers of the high growth you are presenting in year two?
- How do you expect to monetize your idea if you are giving the app (your product) away for free?
If you are not able to support the fundamental assumptions driving the forecast, or the implied assumptions are nonsensical, the pool of potential investors may become disinterested and move on to the next investment opportunity.
Determining relevant valuation multiples also presents a challenge when valuing a young startup company. A valuation multiple is basically a ratio with a value indication as the numerator (equity or enterprise value) and a financial or operational metric as the denominator (revenue, earnings, users). The negotiating process during financing discussions often focuses on what valuation multiple should be used. It is then critical to make sure the benchmarks you and your advisors rely on are meaningful and do not place too much emphasis on guideline public companies or guideline transactions that are vastly different than your startup.
Maybe you view your startup as having high value because of its unique nature and don’t feel a comparison to a mature or a much larger industry player (or a billion-dollar acquisition multiple) is relevant. Yet, your investment advisors have developed a range of multiples you should expect to realize in your next funding round based on these comps. This is the primary disconnect between valuation theory and application in a financing setting.
Funding opportunities, like your startup, will be unique. The investor group, economic and industrial landscape, and capital market outlook may have shifted (favorably or unfavorably) since the benchmark transactions or even in the time since you started shopping your business. Ultimately, the value of your company is only what a buyer is willing to pay for it, regardless of what you think its worth.
So how do you mitigate these challenges? Here are a few suggestions:
- Do your homework. Research your industry and become an expert at explaining and justifying the value expectations you have for your business. To command a premium valuation or improve the likelihood of closing a round of funding, you’ll need to demonstrate why your product or service can maintain a share of the target market.
- Show off your startup’s best attributes without hiding its weaknesses. Be prepared to disclose the areas of your business model that could be improved because this is where the right buyer may find additional value.
- Learn the dynamics of your growth drivers you plan to benefit from as your company grows.
- Study the details that make up your financial statements and be prepared for scrutiny. Be flexible and expect potentially significant changes to your plans over the financing cycle for your startup.
- Commit to the financing process; it could take a while. Closing a funding round or executing a transaction to sell your startup could take 12 to 15 months.
- Maintain professional skepticism of your advisors. Even when you believe incentives are aligned with you and your advisors, you have more skin in the game and are bearing the greatest risk.
Understanding the process and being prepared will help minimize surprises and improve the outcome for your startup.
EQ is partnering with Brown Smith Wallace to bring you a series of stories on topics like startup valuations, tax planning and more. Stay tuned for more posts from the Brown Smith Wallace St. Louis team.