If you are familiar with Shark Tank or Dragon’s Den, then you probably know how venture funding works. If you are not, it’s pretty basic. Most entrepreneurs don’t have the money to bring up a startup. So, they go to venture capital firms, a.k.a the people with the money. If they like your idea, they give you money for a certain share in your company.
Although the whole process sounds very easy, it is not. Very few startups get the fund from venture capitalists, and when I am saying very few, it is not an exaggeration. Less than 1% of businesses receive venture funding.
In this world of technological wonder, you might think creating a tech startup is easier than other businesses but is quite hard. Besides, it takes longer for tech companies to turn a profit than other businesses. For example, the music selling giant Spotify was founded in 2006, but it wasn’t until 2019 that it could turn a profit.
Where To Put Money And Where Not: Investors’ Guide To Tech Startup Valuation
Tech companies are always a risky venture. The investors are wary of such a company. When the internet was opened for the general population in the ’90s, it was estimated to be the next big thing. Investors spent billions in tech startups in the dot com mania.
Dozens of startups sprouted each week, with no shortage of funding. But it turned out to be a classic boom-bust cycle, where the bubble burst only after 18 months. Only a few startups survived the market crash.
Good ideas are not enough to get funding. Investors want to do a thorough checkup before spending millions. There are multiple approaches to judge a company. Let us discuss a few here.
Market Multiple Method
In this method, the recent startups similar to the one in hand are taken into account. Then the potential investors see how those startups are doing and based on their market value, a base multiple is set. It is the multiplication value that the company might fetch if it follows the tracks of similar ventures.
The problem is, it is hard to find startups with similar approaches. The purpose of the startups is to do something novel, and so, identical startups are often hard to find. The startups are also reluctant to share their early business transactions in fear of competition.
Future Valuation Multiple Method
It is pretty similar to the aforementioned one. The growth, cost, and expenditure projections are taken into account, and the future prospect is calculated. If it seems to be a good investment, then the money is invested.
Valuation by Stage
The investors may set a goal for the startups for various stages. The goal can be, to reach a value of 1 million in an estimated time. And then 2 million in a given time and so on until the startup gets a real footing. This approach is called Valuation by Stage. The advantage is that, if in the early stages, the startup fails to reach the set goal, the investors can pull out money.
Discounted Cash Flow
Using this approach, the investors predict how much cash flow the startup will generate. Then the value of the cash flow is calculated with the expected investment return. A higher interest rate is given to the startups due to their higher risk factors.
But this method is not foolproof either. Startups are highly unpredictable. The whole process depends on how good the analysis is for the future of the startup. No matter how good it is, calculating the distant future is always a gamble.
This was introduced by Dave Berkus, a venture capitalist. In this approach, a startup is valued by five key factors
- Basic value
- Strategic relationships in its core market
- Production and consequent sales
Based on these five factors the market assessment is made. Every factor adds half a million to the market value of the startup. This method predicts every early startup has the potential to reach up to 2.5 million.
Risk Factor Summation Method
Businesses are always associated with risk. In the pursuit of becoming a billionaire, bankruptcy is always a possibility. There are different risks that the investors must take into consideration.
The economy can change, there is a security risk, operational risk, etc. The investors calculate the initial value of the company. Then using the Risk Factor Summation Method, it is calculated whether the risks are positive or negative. Then it is added to the initial value.
The Seven Questions
In his book, Zero to One; American Entrepreneur and the co-founder of Paypal; Peter Thiel, argues that tech startup companies must answer YES to seven questions to secure a good future. The questions are as follows:
- Is it possible to create breakthrough achievements with the business rather than incremental improvement?
- Is it the right time to start the business?
- Is the business starting with a big share of a small market?
- Does it have the right kind of people?
- Does it have a good distribution plan?
- Will the company be relevant in the distant future?
- Is it a unique approach that others haven’t thought of?
Even with five or six good answers, the companies are likely to survive. But having fewer than that, the company is doomed to fail. It can be a litmus test for the startups for proper evaluation.
No matter what approach is followed, there always remains uncertainty when it concerns the startups. When we look at the approaches, we can see one thing in common in all of them, that is prediction.
Some methods compare startups with similar approaches, hoping that it will bring the same result, some put an arbitrary market value and some look hopefully in the future, expecting it to bring prosperity.
Although few startups are lucky enough to get funding, only a few of these very few are destined to become tech giants. Many promising startups fail, despite having a promising initial valuation. Generally, for any venture capitalist firm, the most profitable one or two businesses return more investment than all the other investments combined.
So, investing time or money in a startup is a gamble that both entrepreneurs and investors must not tread lightly; this article can give you a tour for a guide to tech startup valuation.
Read More: Amazon Buys MGM for $8https://upstarters.xyz/amazon-buys-mgm-for-8-45-billion/.45 Billion
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