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There is a lot of talk going around today about valuation and valuation markdowns. In this article, we will look at the key factors that help arrive at a valuation. But before that, for those not familiar with how the startup ecosystem functions, here are some basics.
What is valuation?
In simple words, a business valuation determines the economic value of a business or company. To figure that out, many factors are carefully looked using objective measures and evaluation of all aspects of business. This includes financial performance so far, path to profitability, the assets and liabilities of the company, the target addressable market, and competitive edge, among many others.
Why is valuation important?
A valuation figure helps founders and investors arrive at a fair estimate that will make business decisions and investment negotiations easy. For instance, it helps to decide ownership, in taxation and when the company is looking at mergers and acquisitions or when it wants to sell the company.
Why is regular valuation crucial?
International funds regularly assess the value of their portfolio companies on a quarterly or yearly basis. “This involves comparing the share prices of unlisted firms with their publicly listed counterparts. In the face of market corrections, these funds adjust valuations based on company performance and growth,” said Ankur Bansal, co-founder and director, BlackSoil Capital.
Regular valuation analysis helps startups rework their strategies. “They provide an opportunity for startups to recalibrate their strategies, improve operational efficiency and focus on building sustainable business models. In case of markdowns, by addressing the underlying issues that led to the markdowns, these startups can work towards a better valuation in the future,” said Prasad Vanga, CEO, Anthill Ventures.
Here are the 6 key valuation parameters that funds look at to arrive at that crucial figure.
Size of the company
The first and easiest parameter to keep is the size of the company. The smaller the business, the lesser the value of the business. This is because larger companies would have a more evolved set of loyal customers. They would have a stable team and they would have found the product-market fit very soon in their journey.
Profit margin
This is again a simple but effective principle to apply while determining the value of the company. Businesses with higher margins are valued higher than the ones with smaller margins. And, this is done based on the analysis of current sales and revenue. Strong gross margins with recurring revenue showcase a stable cash flow and strong unit economics.
Competitive advantage
Competitive advantage will not only help any company scale faster, but it will also help the businesses live longer than the founding team. It foolproofs the future of the company. This is because this edge will help them protect the business not only from current competitors but others as well. As Warren Buffet said, “so we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year.”
Market size
Companies that have a good Total addressable market (TAM) showcase the revenue opportunity that exists within a market for a product or service. Also, companies that have the scope to expand to different segments and geographies impact value determination. Businesses that are concentrated on one particular sub-sector is susceptible to negative disruptions. Often this interferes with the valuation decision.
Path to profitability
More often than not, even if the company is not showcasing profits right now if the path to profitability is strong, it can work positively in valuation determination. The best way to demonstrate that is to analyze if it has a solid growth rate. According to experts, any business that is growing at 25-30 % has good traction and is on the path to profits.
Strength management team
A team can make or break an organization. A strong founding team that has entrepreneurial qualities can help a company scale faster and pivot if need be. Also, in the case of two or more co-founders, investors often look at how well they work together _ if they have divided the work and other priorities in a clear and comprehensive way. A management team with talented hardworking team leaders will result in the company being assigned a higher value.
This article is from Entrepreneur.com
