When building a startup, one of the most important things to understand is the value of the company. The problem facing many entrepreneurs is how to value something that does not have any solid data yet.
Understandably, a high number of startups get this initial valuation wrong. Sometimes they are only off by a small figure, while other times they can be widely over- or under-valued.
Pitching to investors
The first reason for this is that there is a tendency for startups to over-value themselves in order to present as a good investment opportunity. A company’s value is important to potential investors, as it gives them an idea of what their share of a company will be worth, should they choose to invest.
A valuation during the early stages of a startup is not merely about the present value. It should also reflect the potential for growth. It is this that can make the valuation process so tricky.
A second reason the valuation may be incorrect is that entrepreneurs at the centre of a startup can have a hard time seeing it from the outside as well as the inside.
This tendency to not be able to see clearly when it comes to one's own startup is mirrored in the results of a 2018 analysis of failed startups, carried out by CB Insights. According to the study, the main reason that startups fail is due to there being no market need.
This result highlights the difficulty for entrepreneurs to take an objective approach to their company. Often they believe so passionately in their product or service, that it can be hard for them to see that the rest of the world does not share their view.
No existing competition
A third reason valuations tend to be incorrect is that the market they are entering may lack competitors. This is particularly relevant in the case of innovative startups who are launching a product that is the first of its kind.
A lack of competition can arguably be a reason for a high valuation, but without clear comparisons, it is difficult to make a secure judgement.
High or low, what is best?
Some entrepreneurs may be of the opinion that a high valuation is better than a low one, even if this initial valuation turns out to be correct. There may be a higher chance of securing a significant investment for a startup that has a better valuation, and acquiring an investor will, in turn, add value to the company.
Investors look at more than just the valuation of a startup. They will need to know how the company has arrived at their valuation. If investors are not convinced, then the too-high valuation will do more damage than good.
In the case of applying a valuation that is too low, an entrepreneur may end up having to give away more of their company in order to secure an investment.
There are cultural differences to take into account. In some parts of the world, it is seen as a positive thing to over-value one’s company. Some cultures see it as a sign of confidence and belief in oneself.
Meanwhile, in other cultures, it is more favourable to be humble, and under-state one’s achievements.
It is the responsibility of every startup to know who they are pitching to and what the customs are where they are. Understanding this will give them a higher chance of getting their initial valuation right.
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