Avoiding Startup Valuation Mistakes: Guide
Investment can bring stable additional income to venture capitalists and help business development. The problem is that choosing a project is a challenging process, especially when it comes to startups. Unfortunately, the statistics in this regard are inexorable:
- ~30% of startup investments do not pay off;
- ~30% payback with a net present value (NPV) of approximately 0;
- ~30% returns at the level of low-risk investments (it would be easier to put that same money in a bank);
- and only ~10% of startups bring relatively decent market income to their investors.
This leads to more and more venture capitalists abandoning the idea of investing in startups. However, we advise giving innovative technologies another chance by carefully examining the projects in advance. Now let us discuss the process in detail.
What is the project doing?
The first question that interests a venture investor is what a particular startup is planning to sell? Here the concept of a Unique Selling Proposition (USP) comes into play. As a rule, most venture capitalists seek to invest in products that are not yet present on the market, something fundamentally new and innovative. Nobody wants to invest into reinventing a bike, so the final result has to be something unique and unparalleled.
Determining the target audience and a sound assessment of the people’s needs is key for a reasonable market evaluation and a correct sales prediction. One has to make sure that the startup founders are aware of their target audience, being able to not only calculate its size and boundaries but also justify the audience’s need for their product, as well as correctly assess its paying capacity, which brings us smoothly to our next question.
We sometimes see that a company is developing a product, but at the same time, it cannot figure out who might be interested in their novelty. This leads to a lack of proper marketing strategy going forward, and the development never bears fruit.
Hundreds of startups have collapsed into oblivion due to incorrect product pricing. On the one side of this thin line fell those companies that set their prices so high that the target audience could not afford them, while on the other side dumping lovers fell victim to pricing policy that prevented them from covering production costs. The price should be justified considering the innovation’s usefulness for the target audience and the latter’s ability to pay.
Some projects calculate startup costs and divide them among several clients, resulting in an exceedingly high price that scares potential clients away. It is better to set a price that allows the project to pay off in full within the first couple of years.
Required Investment Amount
Any business that claims to capture a significant market share needs to meet certain expenses: equipment, research, advertising, and other costs. When deciding to invest, it makes sense to familiarize yourself with the startup’s budget and consider whether it is justified and meets the real business needs.
Nobody likes to overpay. So, if you understand that a startup’s leads are asking for inflated salaries for themselves and their employees, the project most likely should be abandoned.
When should you expect the first profit?
Every investor is concerned with obtaining a return on invested capital. Moreover, in the venture business, the expected return is relatively high due to being considerably more risky. As was mentioned above, about 30% of all startups yield returns at the level of low-risk investments, which is basically equivalent to failure for the venture capital industry. Only investing in a business that can bring the required and justified return makes sense.
As a rule, venture capitalists are prepared to wait until the project finds its footing and begins to generate real income, but the delay must be justified. For example, a startup owner can say: “We plan to earn a certain amount of money during the first year, which will be spent on upgrading the project or introducing new features, and then, in the second year, we expect to meet such and such profit margins.”
A reasonable venture investor safeguards their capital, soberly assessing business risks: additional costs, unmet sales predictions, failure to reach the planned target audience, etc. Only after realizing and accepting all these risks can you invest in a startup to obtain the desired return. The lower the chance of failure, the more likely a venture specialist is to be interested in a certain project.
For venture capitalists, the character of the person they partner with is fundamental. No matter how great your idea is, if you have previously been involved in fraud, or if the investor simply does not like you because, say, of the color of your hair, then you should not count on a future cooperation with them.
Key Startup Valuation Points
The company I work for evaluates startups as follows:
- If a startup is aimed at a new niche, this makes it unclear where to dig for a detailed evaluate it. There are no similar competitors, and the data can be quite limited;
- If a startup is similar to an already existing product, it may be difficult to collect and evaluate data. One should collect information about the current startup and its competitors. The more information we dig up, the better we understand what the newcomer to the scene is capable of;
- When evaluating a startup, it may be necessary to conduct research (if the startup has not done it already). Qualitative research includes interviews, expert survey, and focus groups. These help understand if there is a need for the product offered by a startup on the market. Quantitative research includes phone surveys and questionnaires that also help understand if there is a demand for the product from the target audience;
- During the assessment, various tools can be helpful for indirectly confirming our theories and conjectures. Say we have a startup that claims to have invented an engine that runs on water, and we discover that there was a startup with a similar theme back in 2007, but it failed due to being too expensive to produce, limited supply of suitably pure water, and a substantial impact on the environment, which caused a surge in protests. In 2022, when the new startup launches production, the process might have become cheaper due to new technologies, or a process has been devised for proper water purification. We look at people’s concerns about the environment using this service https://trends.google.ru/trends/explore?date=all&q=ecology and realize that the public is not as worried about the environment now as it was in 2007. The price of iron, which the engine is made of, has also dropped from 150 to 100: https://tradingeconomics.com/commodity/iron-ore, which made production cheaper. All of this is just a minor example of the toolkit that allows you to draw conclusions more quickly and effectively. A combination of different methods enables the researcher to more easily consider a particular startup’s pros and cons, but every investor also has their own assessment methods and criteria.
- Startup owner’s portfolio can also be an essential factor. Someone with seemingly little relevant experience may turn out to be an expert fraud. Giving money to a scammer is also a result of an evaluation error.
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