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Understanding the link between a startup’s value and innovation

Posted by Shivali Anand

April 14, 2022    |     3-minute read (415 words)

Startup valuation frequently boils down to one of two main approaches: top-down or bottom-up. The top-down technique assists you in determining the worth of your business based on the size of the addressable market and predicted market penetration, as well as the pre/post-money valuation of similar firms.

Startups with a proven financial track record, on the other hand, can take a bottom-up strategy and apply discounted cash flows or other more complex valuation approaches. Alternatively, they may just use the EBITDA multiple to determine the worth of their company.

However, even EBITDA-based valuations employ varying multiples for firms in different industries when it comes to selling or funding. Some are valued at 25 times EBITDA and others are sold for just 2.5 times EBITDA. According to Equidam data from November 2021, enterprises in the coal industry sell for an average multiple of 5.59 X EBITDA, while software companies are valued at 30.92 X EBITDA.

This begs the question: Why are certain investors prepared to pay a premium for certain firms while others are not? It's because they're on the lookout for new ideas.

Investors are drawn to cutting-edge technology firms and are constantly seeking new ways to cut costs, enhance performance and increase profits. As a result, a greater valuation (i.e., a larger earnings multiple) implies that investors have higher expectations for the company's future profit potential and growth.

Deciphering the link between innovation and valuation

High-value multiples for software businesses would suggest stronger growth expectations based on the previous. But why are software companies anticipated to expand at a far faster rate than coal companies? The leading cause for this is innovation.

A software firm is extremely scalable. It has lower marginal costs and if it can innovate and develop cost-effective methods and procedures and offer distinctive value in the market, it will expand quickly and become a market leader in its niche. Furthermore, the IT business is new compared to coal or oil and gas. Because technology is still evolving, there is more innovation potential.

In a word, your startup's worth is directly proportional to your capacity to innovate, adapt and prosper in an ever-changing environment.

Recap

Investors are prepared to pay high valuation multiples for firms that promise rapid development while potentially establishing a defensible business solution because of innovation.

Better yet because innovative businesses are virtually always more valuable, embracing innovation may be the best thing you can do to significantly increase your firm’s valuation.

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