What it takes to get better deals Part 2: – Valuation of a Start up
This is the second part of the series “What it takes to get better deals” Read part 1 here
Once upon a past life, when launching a tech based product, the public relations professional we had sought to help with our product launch was briefing us on the likely Q&A of our product launch. We seemed pretty good until he asked “how much investment went into the creation of your product?” To which we replied with a dumb spell.
Valuation of a product or business start up is the cumulative account of not only the final product’s value but also of the labor and time resource spent to complete the project and the value generated from addressing the market need. In turn, valuation may affect the pricing of the service or product being produced as you seek to get the best possible returns in the shortest timeframe possible. Start up valuation also affects the asking price of a startup when one needs further capital financing with investors.
To understand the start up valuation process, one needs to accurately place their business within the business development stages.
Start up valuation for the purpose of sourcing external funds may vary largely on the stage of development that the business is in at the time it seeks the external funds. The different start up stages represent unique achievements, assets base and risks, which may affect the final business value.
Ideas Phase: at this stage, a start up will normally have no historical financials or tangible assets to back the valuation assessment. Valuation within this level has often been cited to be “an art, not a science” as there are no measurable items to determine a fixed outcome. Valuation thus tends to be based on how convincing their strategic plans and business models are. Finally one may consider valuation on patented/copyright research work done as well as feasible business plan which a sound financial outlook.
Conceptualization Phase: At this level, the entrepreneur has put in some amount of work in actualizing their business plan and in the case of tech start ups, may have a tangible asset in the form of the product prototype, which performs the most basic functions intended in the business plan. Valuation at this level critically examines the product and its capacity to perform the desired task with minimum additional work. At the financial level, valuation examines the financing input thus far, as well as the costs incurred. Other items that may be valued include: the incorporation documents, human resource, and time capital employed in the actualization of the product prototype. The risks of product viability are also weighed in to determine the sustainability of the prototype going forward.
Sometimes within the start up phase, the product/service provision may have been ‘leaked out’ to an actual market in small quantities that are meant to gauge the market’s reception to the end product. The income flow from this sample size may help in gaining the product traction, where quick intake of the sample product/service reflects a sustainable market appetite which may impact positively the valuation outcome. The point of a company’s existence is to get users, and if the investor sees users they will be more convinced to fund your idea.
Business Growth Phase: This is where there has been a successful product launch and introduction to the market, thereby proving the business model sustainable. At this level the start up may have achieved a steady revenue flow and managed to cover some of their start up expenses, even though the business is not profitable yet. Funds sourced here are meant to push for medium term developments such as: actualizing the marketing plan, hire more staff and management, and establish the company’s position in the market. Compared to the other levels, funding at this stage tends to be short term, to complement existing cash flows and as such valuation at this stage is based on the business’s historical performance and its ability to meet its immediate operational needs.
Founder’s Goodwill: How successful a start up founder has been on previous ventures, and their ability to demonstrate their success may increase their value. Reputation is an asset.
From the investor’s perspective, items that may influence the start up’s valuation include:
Exit options: When an investor is getting into a partnership with a business, they consider among other things what options are available for them should they choose to exit. Where a business operates in a rather rigid environment with limited exit opportunities, it is likely to be considered a high risk venture which may bring down the value of the start up.
Business Environment: How sustainable is the industry the start up is operating in? Is it going to be as relevant and as rewarding twenty years from now when my investment is supposed to mature? Such are the considerations investors are likely to make and the more appealing an industry environment seems in the future the higher the valuation of the business in the presence.