Is the startup’s valuation a problem to be researched scientifically?

A few years ago, we started to invest in tech startups at an early stage, and we faced the intriguing question about the best methodology or technique to valuate companies without financial records. After some research about the best practices in the industry and some literature reviewed, we found that the best way to do it is to try several methods and find the best fit for the specific startup-market. At the end, the formal valuation is a starting point to negotiate.

After many iterations of the models, a better understanding of the market conditions of capital and quality entrepreneurs density, the topic keeps being the same:

Startup Valuation at an early stage still being more art than science.

On one hand, you can find a lot of empirical and scientific research about the determinants affecting the valuation, and most of them are associated with qualitative and subjective factors between the entrepreneur, the team, the product or service, the investor and the market. But, on the other hand, the majority of the most used methods are based on quantitative factors, with DCF in the first place (DCF of guessing numbers). Besides the qualitative considerations, investors often rely on more quantitative methods to achieve a more precise comparison among investment opportunities.

Probably there is not an answer in the finance area, perhaps in the strategic management area, or not. Where is the answer? Some fast data about the valuations in the last ten years of rounds in several places show a high standard deviation in a pre-money valuation, and this increases in less capital intensive markets like Latin America.

Valuations are in the hands, brains, and hearts of investors.

This phenomena recently attract the interest of the US Securities and Exchange Commission to observe the practices applied by investors to startups and demanding a comprehensive understanding of the determinants that impact the valuations of startups in the venture capital (VC) context.

Even the amount of transactions on early stage, there has been ongoing criticism about the scarceness of and explicit calls for further research on the factors affecting startup valuations. Currently, literature is not only sporadic but also very fragmented and lacks a conceptual framework integrating the existing empirical research on the determinants that impact the valuation of startups in the VC market and most of the investors and entrepreneurs excessive reliance on commercial VC databases, which only state the final valuations, but the process itself remains a black box.

Studies addressing venture capital decision making have occasionally been criticized due to the validity methods used where the venture capitalists report how they believe they decide, instead of reporting how they actually reached a decision.

Valuation of an entrepreneurial firm is one of the most critical and challenging issues facing both entrepreneurs and venture capitalists. Each potential match has a valuation, and the valuation represents the expected net present value, at the time of the investment decision, also aligns the ambitions of the entrepreneur and investor and reduces the source of potential conflict between them.

The valuation process still being complex, understanding the extent to which a firm is weaker or stronger is often very difficult for venture capital investors, because they invest in new technologies, non-existent markets, and unproven teams. Also, the characteristics of the evaluated startup are very dynamic; the information asymmetry can lead to opportunistic behavior in the form of adverse selection and moral hazard, and the density and dynamics of the market where the firm is evaluated affects the equation.

If the valuation process is more art than science, would it be useless to research it? Can we determine a better technique to understand the qualitative factors? Can we combine quantitative and qualitative valuation methods? Can we create a conversion rate for valuations between different markets? Can entrepreneurs hack the valuation process?

Some sources:

• Valuation of Early Stage High-Tech Start-Up Companies​.
• What Do Entrepreneurs Pay for Venture Capital Affiliation? ​
• Firm Valuation in Venture Capital Financing Rounds: The Role of Investor Bargaining Power.
• Evaluation uncertainty of venture capitalists’ investment criteria.
• Startup valuation by venture capitalists: An empirical study.
• Investment cycles and startup innovation.
• How Smart Is Smart Money?