How To Increase Valuation
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I have a patent and that is a reason to determine a high valuation!
My team has a lot of experience in this field, so our company should be valued more!
We have a unique sales team and that should set our valuation higher!
But what are the actual drivers of valuation?
It is a common belief among entrepreneurs and startup founders that one aspect of the business contributes to 90% of its total value.
However, the way to calculate the value of any business is always to take into account a number of factors and sum up their contribution.
For example, building a startup based on an extremely revolutionary idea is by itself not enough to determine the valuation. This idea must be considered in context. The execution of the idea and the value that comes out of it is only one of the factors that contributes to the overall value of the company.
Before we move on, we should mention that our discussion is based on the assumption that any business is able to generate cash flows. We take this into account because we are looking at for-profit entities whose intrinsic purpose is to generate cash flows for their shareholders. Therefore, the value of a business should be based on the ability of the company to generate cash flows in the future.
So, how to increase valuation?
A business aspect adds value to the company if, and only if, it can decrease the implied risk or, alternatively, it can increase cash flows.
Let’s take an example. We have 2 companies that are very similar in terms of stage of development, market, type of product/service, and growth potential. We are assuming that these companies can reach an exit of a similar magnitude in approximately the same amount of time.
The company with the higher chance of reaching an exit should have a higher valuation today, because the risk associated with that company is lower.
Following the same example, suppose company A has more experienced founders who have already started a company before. On the other side, company B’s founders are first-time entrepreneurs. Which company will have higher chances of success and subsequently a higher value? The answer is company A.
The conclusion from this example is that you should ask the question: “Does this factor, put in the context of my company, increase my cash flow or reduces my risk of failure?”. If the answer is yes, then the factor does increase your value.
Take the following three common factors that can potentially influence the value of a company. This is the mental process that we would follow to analyse the impact of these factors on company value.
A patent does not necessarily bring value to your business unless it is put in a context where it generates cash flows.
Patent can increase chances of reaching a certain threshold of cash flows, as long as obtaining it is functional to lowering competition. Lower competition will in turn create higher margins and higher cash flows. This will also result in higher business value.
2| Industry experience
What does experience in the industry mean? Is it relevant and what does it say about the ability of the founders to build a business?
Experience can add value as long as it is relevant to achieving the company goals faster and with less mistakes as compared to someone with less experience. Consequently, the more experienced the team is, the more the business value increases.
3| Unique sales team
What does it mean that your sales team is unique? What is their distinct capability to generate cash flows?
The unique part about the sales team should be the ability to close more deals and close faster, which will have an impact on the cash flows of the company and in turn impact the value.
To sum up, always put these unique factors in context with your specific company and consider how the factors will assist you in achieving your company goals.
Negotiating with investors
In an investor meeting, you always have to present your company and its features following the logic we outlined above. In addition, you have to explain why this factor contributes to the overall value and defend why it affects the value by such an amount.
Bear in mind that sometimes you cannot set your valuation higher than your cash flows even based on factors such as the ones we mentioned above. In the case that the cash flows are maxed out – meaning for example the market is not big enough, relevant founder experience cannot account for a change in the valuation.
When calculating the business value always focus on the elements that will lower the risk for your company or alternatively increase the chances of reaching a certain amount of cash flows.
The framework we introduce here is drawn from experience while interacting with many entrepreneurs and businesses. We found this to be working for a large percentage of all businesses. What is your experience? Do you agree with our ideas? Give us your take on which factors add value to your company in the comments!