In the world of startups, we hear a lot about valuation. We rank companies based not on their revenues and profits, but on their valuation. This is intriguing, because by all accounts a startup valuation is far from an exact science. So when you hear, for example, that a company like WeWork has a valuation of $21 billion but is not yet profitable, it’s worth digging a little further into why that is.
The definition of what a startup valuation is depends on who you ask. As Seedcamp puts it: “The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.” Others will say simply that the value of your startup is what someone is willing to pay you for it.
The reason why startup valuation is so tricky is twofold: the first reason is because there are so many variables. By their nature most startups don’t have a history, past revenue, or previous earnings to go by. For that reason, according to Forbes, “Angels can look for clues from similar startup deals in the same region and industry. Like real estate, valuations will go up and down depending on market forces.”
The second reason valuation is tricky is because the two main parties involved—founders and investors—essentially have totally different motivations around what they want the valuation to be. As Forbes put it: “Entrepreneurs want the value to be as high as possible and angels want a value low enough so that they own a reasonable portion of the company for the amount they invest.” There is also information asymmetry between investor and founder, as the founder knows the ins and outs of their business and might try to conceal facets that wouldn’t be pleasing to an investor.
So you can see why a lot of startup valuation comes from a mixture of guesswork and negotiation. A company like WeWork, which specializes in coworking spaces all over the world, isn’t actually earning anywhere near $21 billion in revenue at present. But its “value” likely comes from the fact that it is in a growing sector—the gig economy and distributed office space—that is slated for a lot of growth in the coming years. It offers investors not so much a rock-solid business model, but a slice of a growing market in the years to come.
This may run counter to another kind of startup, which might have robust profitability for its size but not be operating in an industry that investors or sectors see as bullish. As Seedcamp went on to say: “This means that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either (regardless of what you are doing), then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have).”
In essence, there is no perfect methodology to value a startup before it’s taking on revenue. Even when it is, it can be hard to gauge the revenue it’s taking in now versus what it might take in the future. As Forbes summed up, this makes “it even more important for investors and entrepreneurs to know how the number is derived.”
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