Start-up valuation is often not at the top of the to-do list for start-up founders, especially in the early days. But it should be. Just like it is with human newborns, what happens in the first days, months and years for freshly minted businesses has an outsized influence on determining their future. Like it or not, having an accurate business valuation is crucial for your start-up’s future success. Indeed, an on-point valuation enables some start-ups to grow with ease while others struggle. So, we’re looking at the common mistakes start-ups can make that dent their valuation. And we’ll step you through the tried and tested methods you can follow to avoid these pitfalls when you set up your business and value your venture as it grows.
Beware the five follies of start-up valuation
When it comes to facepalm moments for start-up valuations, we see founders and innovation leaders (on a depressingly frequent basis) make five major mistakes when valuing their start-ups. And for that reason, we’d like you to avoid these pesky pitfalls. Read on and keep these five follies in mind before you embark on valuing your venture.
1. Not understanding value
All too often, we see start-up founders either undervalue or overvalue their ventures. On the face of it, these errors are polar opposites. But in reality, they are two sides of the same coin and hinge on start-up founders and leaders not understanding what value is in relation to their start-up.
Undervaluing
Founders and leaders often miss a trick and underestimate the value of their start-up by only focusing on their venture’s tangible assets. They zero in on their innovative product or service and its price tag — current or future — and overlook the intangible elements. Any business (even an early-stage start-up) holds intrinsic value for simply existing. This includes the company’s goodwill, its brand, and what it’s worth to others in the long run. Always get an expert opinion from an accountant or a business adviser specialising in start-ups on the value of your start-up’s X-factor and add it to your valuation. That way, you won’t constrain your venture’s growth potential from the outset.
Overvaluing
While some founders don’t stop to consider their company’s impalpable qualities, others over-egg the pudding when it comes to their start-up valuation. Some founders and start-up leaders can develop an overinflated sense of their start-up’s brand value, goodwill and future potential. Another common misstep is founders who drink the Kool-Aid in terms of the retail value of their start-up’s products and services and overestimate the market size of their offering. Both mistakes can significantly distort the true value of a business and store up trouble later in the start-up growth journey. But both errors can be easily fixed. So don’t worry: just address these issues if they’ve happened in your venture.
2. Acts of self-sabotage
Self-sabotage is something everyone can fall victim to whether knowingly or unknowingly. The key to minimising its negative impact is to recognise that you (along with every other start-up founder or leader) are susceptible. Then, try to identify your potential blind spots and weaknesses, and those of your founding team. But before you launch into a bout of self-reflection, here are a few pointers on the common own goals we see some of our clients make.
Intellectual property
Not locking down intellectual property (IP) rights is top of the list, because it can torpedo your start-up’s prospects. Talk to a specialist IP lawyer as soon as possible — even before you launch your start-up — to protect your business from the get-go.
Finance and governance
Under-estimating how much capital you will need to reach key milestones on your start-up journey and how long it can take to attract investor capital share second place. Both pitfalls can be remedied by having a financial strategy and plan and leaning on your ecosystem as a sounding board and for regular reality checks. Skipping the need for governance and processes is number three because they will ultimately impede your ability to attract investors and customers. Investors and customers both prefer to deal with businesses they can trust and putting in place governance and processes will address this important requirement.[1]
3. Choosing the wrong corporate structure
This mistake is in a category all of its own for good reason. It’s a seemingly small and easy mistake to make, but it’s one that will have a huge impact on your start-up’s success. Tempting as it is, don’t launch your start-up as a sole trader. While it’s the fastest and cheapest corporate structure to get your venture off the ground, it will constrain your ability to invest in research and development (R&D) and attract funding.
Investors
Venture Capitalists and other investors will avoid sole-trader entities because they represent too high a risk. Before they open their cheque books, investors want to see evidence of a strong founding team with an array of skill sets and experience as well as an innovation with exceptional growth potential.
The R&D Tax Incentive
Equally, before you can access the Federal Government’s R&D Tax Incentive and receive 43.5 cents on the dollar for your R&D spend, you need to be an eligible entity. Under the rules, individuals, corporate limited partnerships and trusts are typically excluded. So make sure you engage an accountant or an R&D Tax Consultant to ensure you choose the right structure for your innovation business. Otherwise, you could not only lose out on accessing the R&DTI refund but also on R&D financing to access it early.
4. Underestimating the role of ecosystems
We can’t say this enough: start-ups that belong to an ecosystem community are more likely to succeed. Looking beyond your start-up’s founding team is a smart move. It will give you access to potential partners such as service providers, for example, R&D financiers and Research Service Providers, and enablers such as start-up incubators and accelerators. Start-up ecosystems deliver top-flight advice and support without the top-flight price tag. Surrounding yourself with the right ecosystem, resources and support can add intangible value that translates into real value. And if that’s not reason enough, start-ups that joined an incubator have a five-year survival rate of 87% compared to a 44% five-year survival rate for those that don’t.[2] Read our articles, How to find a start-up ecosystem and why it’s important and Collaborate or die: superpower innovation with community.
5. Not using a suitable start-up valuation methodology
Arriving at an accurate start-up valuation is part science, part art. And there are a host of tried and tested methods you can choose from. Your decision may be shaped by personal preference, a recommendation by a trusted adviser or perhaps the method that your peers in your sector tend to follow. Either way, the key takeaway here is that you apply a recognised and reliable method when valuing your venture. Don’t make the mistake of convincing yourself that start-up valuation methodologies are not for your business, otherwise, you could end up limiting or even scuppering your company’s true potential. Ultimately, investors will want to know how you arrived at a valuation for your start-up. Opening your books, showing that you’ve engaged professionals for advice and used an established methodology are essential to landing a backer.
Start-up valuation methodologies
You don’t need to wing it or feel your way in the dark when it comes to valuing your start-up. We highly recommend seeking expert advice. Speak to your accountant or R&D Tax Consultant in the first instance and take it from there. But to help you be more informed before you begin your start-up valuation journey, here are a few of the tried and tested start-up valuation methods our clients use.
The Berkus Approach
Sometimes called the stage development method or the development stage valuation approach, The Berkus Approach is the brainchild of American venture capitalist and angel investor Dave Berkus. This methodology centres on analysing five success factors and assigning each a value of up to $500,000.
The five factors The Berkus Approach focuses on are:
- Basic value: how strong is your start-up’s business idea?
- Technology: how appealing is your start-up’s product or prototype to customers?
- Execution: how skilled is your management team?
- Strategic relationships in the core market: how extensive and effective are your start-up’s alliances in the start-up ecosystem, and do you have a growing customer base?
- Product rollout and sales: how clear is your pathway to profitability?
Combined, these five factors can add up to a maximum pre-money value for the start-up of $2.5 million. [3] Although the Berkus Approach is fast and simple, its Achilles Heel is its superficial nature. It lacks nuance to account for the complex and often competing interests of start-up ecosystem stakeholders. And its simplicity means that important matters such as financial risk are not fully explored.
The Cost-to-Duplicate Approach
As the name suggests, The Cost-to-Duplicate Approach involves calculating how much it would cost to replicate your start-up. Founders and start-up leaders using this methodology use the data to arrive at their start-up valuation. The duplication costs this method adds up are the fair market value of your start-up’s physical assets, R&D costs, prototyping expenses and outlays for securing intellectual property (IP) rights. Notably, The Cost-to-Duplicate Approach doesn’t take intangible assets such as goodwill, brand value and IP rights into account. So, it could potentially undervalue your start-up.[4]
The Discounted Cash Flow Method
The Discounted Cash Flow Method involves projecting your start-up’s future free cash flow. Free cash flow (FCF) is the cash a business generates after deducting cash flows to cover its operating expenses and capital assets. The method applies a discount to your company’s future FCF. The reason is there is always a risk with future cash flow. To put it bluntly: those sales might not happen, or your investors may fail to pony up the funding they promised. The other reason for trimming a little from your future FCF is that money appreciates over time due to interest. So, the future FCF is discounted back to its present-day value. The Discounted Cash Flow Method involves some more complex number crunching compared to the Berkus and Cost-to-Duplicate Approach. However, it arrives at a valuation using future performance and therein lies its appeal for start-ups which often lack historical data.[5]
The Risk Factor Summation Approach
The final approach we’ve included in our non-exhaustive list of start-up valuation methods is The Risk Factor Summation Approach. The reason for it being our final selection is simple. The first step to using The Risk Factor Summation Approach is applying another start-up valuation first, which this approach uses as its baseline valuation. The Risk Factor Summation Approach comes into its own by quantifying start-up risks and assigning dollar values to them. This method considers how management, political, manufacturing and market competition risks, to name but a few, impact your start-up valuation. The dollar value assigned to these risks is added to or deducted from your start-up’s baseline value. The idea is that this broader approach will provide a more accurate picture of your start-up’s value.[6]
Valuing your start-up with confidence
Taking the time to have your start-up valued accurately will literally pay dividends for your venture in the future. It’s the key to attracting debt and equity funding in the short-to-medium term, and the return on investment you deserve in the long term. But it will require you to call on some expert advice. If you’re running a start-up that’s conducting R&D and you don’t know where to start, our R&D financing experts are a great first port of call. As the established market leader in Australian R&D financing, we’ve built up a network of trusted advisers and experts over our years in business. And we’d be delighted to connect innovation businesses with any of our ecosystem partners. So reach out. Support and no-obligation advice for your R&D start-up is only a phone call or email away.
[1] Yassin EL HARDOUZ (2023). 8 Mistakes Startup Founders Make with Valuing Their Companies. [online] Linkedin.com. Available at: https://www.linkedin.com/pulse/8-mistakes-startup-founders-make-valuing-companies-yassin-el-hardouz-esige.
[2] Business News Daily. (n.d.). How Incubators Help Startups Survive. [online] Available at: https://www.businessnewsdaily.com/272-incubators-increase-small-business-success.html.
[3] Brex. (n.d.). How to do a startup valuation: 8 different methods. [online] Available at: https://www.brex.com/journal/startup-valuation.
[4] Corporate Finance Institute. (n.d.). Startup Valuation Methods. [online] Available at: https://corporatefinanceinstitute.com/resources/valuation/startup-valuation-methods.
[5] EY Netherlands (2019). Startup valuation: applying the discounted cash flow method in six easy steps. [online] www.ey.com. Available at: https://www.ey.com/en_nl/finance-navigator/startup-valuation-applying-the-discounted-cash-flow-method-in-six-easy-steps.
[6] Brex. (n.d.). How to do a startup valuation: 8 different methods. [online] Available at: https://www.brex.com/journal/startup-valuation.