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How Innovation Can Transform Your Business Valuation

Even though startup valuation is a complicated topic, it boils down to two general approaches – a top-down and a bottom-up approach.

With a top-down approach, you can argue for a valuation derived from addressable market size and expected market penetration. Or alternatively, you can see the pre/post-money valuation of other startups in your industry and adjust your own valuation based on a direct comparison with them. For example, Y Combinator offers $125k pre-seed capital for 7%, which suggests a $1.6M pre-money valuation. You can use this as a benchmark for your own valuation.

For startups with financial history, you can use a bottom-up approach. While you can use discounted cash flows (NPV) or other more sophisticated valuation methods, this is usually unnecessary, as most projects are valued based on an earnings multiple.

How do you choose what multiple to use?

There are companies selling for 25.30 X EBITDA (earnings before interest, taxes, depreciation, and amortization), others selling for 2.5 X EBITDA.

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For example, according to Equidam, businesses in the coal industry sell for an average multiple of 4.53 X EBITDA. Oil and gas exploration and production isn’t far off with 5.14 X EBITDA.

On the other end of the spectrum, you have information services at 25.30 X EBITDA and software companies that are evaluated with a 24.35 X EBITDA multiple.

Why are investors willing to pay such a premium to acquire some businesses and not others?

To answer this question, you need to understand that a higher valuation (i.e. a higher earnings multiple) simply represents higher expectations for future business growth from the investors. The main reason a software company could be expected to grow much more than a business in the coal industry is innovation.

A software company is highly-scalable. It has low marginal costs (cost per unit of additional output), and if it manages to innovate and create unique value on the market, it could grow rapidly and become a leader in its own market niche.

Moreover, the IT industry is historically speaking very new compared to e.g. coal or oil and gas, which means there are more opportunities for innovation as the technology is still developing rapidly, a great example being blockchain tech, which followed the web 2.0 revolution, etc.

In summary, innovation is the main reason behind high valuation multiples because investors are willing to pay a premium for ventures that have a possibility of rapid growth while potentially creating a defensible solution.

Since risk and opportunity are the main growth drivers behind any project, innovative projects simply have a much higher chance to grow than non-innovative ones. As a result, investing in innovation could be the best thing you can do if you want to significantly increase the value of your business.

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