“Every number in your valuation has to have a story that’s attached to it. And every story you tell me about a company has to have a number attached.”

This quote, from Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, highlights one of the fundamental truths about valuation.

With any product that you might consider buying, ‘story’ is a major component of that decision. What does that brand represent, what is their track record, who is behind it? It provides qualitative information, giving you a complete picture of the value when combined with comparative data on performance and reliability.

In some cases, where a product is band new, and defining its own market category with a novel approach, it can be difficult to assign value to those metrics. How do you contextualise data on quality if you can’t rank it against competing products? Your decision has to be guided more by the qualitative information: the brand story, company behind it.

The same is true for companies. The process of valuing a company, and where you should focus your attention, is dependent on the scenario.

Traditionally, valuation is a numbers game

Most companies are based on very well established models (hairdressers, supermarkets, mechanics), and valuation is a calculation based primarily on financial metrics.

The story component of that valuation is fairly trivial. It is such a widely understood scenario that from the businesses category alone you can assume most of the remaining details. What matters, and where the focus of valuation lies, is the performance. How well is the company executing on that model?

This results in a valuation process that is achievable in a spreadsheet, and reliable without many concerns or much variance. Relatively low risk, with the matched low potential reward for investors in these businesses.

Startups are the antithesis of tradition

One of the better definitions for ‘a startup’ is a company that disrupts a market through innovation with the goal of becoming the category leader.

Ambition is the name of the game. These companies are pushing the envelope on what we can do, and how certain problems are approached. This is often connected to the digitalisation of certain processes that have historically been manual, allowing much greater efficiency and scale. But how do you value ambition? What is there to measure, especially if it’s a pre-revenue company?

Somehow, you have to build a qualitative understanding of the team, the market they are aiming at, and the business they are developing. This valuation model needs to account for the standard risks and volatility of young startup companies, and support the founder’s story through providing as much of the associated information as possible.

This is the key difference between ‘Valuation’ and ‘Startup Valuation’. The former is concerned with following standard patterns and obvious metrics. The latter is focused on helping investors understand the potential of entirely new ideas, and helping founders tell their story in the most complete and compelling manner. There are more untested assumptions and associated risk, which is why startup investment is widely regarded as pairing some of the highest risk with some of the best returns.

Why Startup Valuation is important for the future

The valuation of startup opportunities, our ability to price them appropriately, is a key component in determining which ideas get funded. Fundamentally, if our approach to valuation does not properly capture the value that startups offer – that unique combination of risk and potential – then we’re not going to be properly allocating capital into the companies that shape our future.

We risk leaving out both ideas and people that don’t fit that traditional mold. We risk building bias into the system, as the compounding reassurance of ‘success stories’ leads us further down the wrong path, leading to a multi-decade misalignment of capital and innovation.

The purpose of the whole fundraising ecosystem around startups is to enable each generation’s great creative thinkers and technologists to venture out into unknown territory. It is in these category-defining ideas, whether they are establishing new markets or new approaches to existing markets, where the greatest returns are usually found.

Startup Valuation is the way to estimate the risk to reward ratio of these endeavors, and as such it should be designed to accommodate entirely new concepts. This is the danger of being driven by comparables and pattern matching, which incline investors to pick a winner from the field and then line up behind them. We shouldn’t care about who gets somewhere fastest, we care about who got their first. Who was pursuing a particular goal before anyone else really understood the opportunity?

Startup Valuation is far from a ‘solved’ problem, and perhaps it never will be. It asks difficult questions about valuing the unknown, but it is critical for us to continuously reflect and reorient how capital is deployed into innovation – and how that changes where technology is heading.