Startup valuation reassessed: against celebrity, sustainability and state intervention

1. Introduction

Due to missing historic data and capital structures, which are substantially different from established companies, the valuation of startups is often referred to as being more “art than science” (Köhn, 2018). Furthermore, startup companies particularly lack data “for estimating competitive effects” (Bryan and Hovenkamp, 2020, p. 331), and Gornall and Strebulaev (2020) found that post-money valuations by venture capitalists for unicorns (“private companies with reported valuations above $1 billion”) were on average 48% above the threshold the authors call the company’s “fair value”. This inconsistency between subjective and actual value shows where factors, like missing information, can lead.

According to Tyebjee and Bruno (1984), a venture capital investment follows a clear structure, with the valuation being one of the most important and challenging issues for both the entrepreneur as well as the venture capitalist. The authors furthermore state that startup companies usually have almost no existing history of performance, meaning that the venture capital (VC) needs to “rely on a subjective assessment procedure, based upon the business plan presented by the venture’s management”. It is thus natural to assume that the management is interested in presenting a particularly high valuation in order to be well prepared for their exit.

According to Samdani (2019), the usage of the discounted cash flow (DCF) method is not as precise for unlisted firms as it is for listed. He also states that valuation multiples like the price/earnings ratio (P/E) or the earnings per share (EPS), which are commonly used as a substitute of the DCF, do not take into account the fact that “the price accuracy of new equity issues is also effected by market-demand information”, referring to Kim and Ritter (1999), Banerjee et al. (2011) and Butler et al. (2014). Again, this shows that typical valuation methods cannot be used as easily for startups as they can be used for companies with a well-established capital structure.

While, for example, Armerin (2014) tries to deliver axioms for the valuation of cash flows in general, an approach to provide an overview of which aspects influence the valuation of startup companies has not been made yet. With our paper, we summarize recent findings about the valuation process of startup companies and particularly contribute by identifying three important and promising research avenues, which we advertise to be put into further research focus. Startup valuation is an important topic as entrepreneurial activities seem to be rising substantially (Kelley et al., 2020), and being able to value them is not only essential from an academic perspective, but even more from a practical point of view because (as stated above) the more common assessment procedures cannot be applied so well for startups. Therefore, given the research gap consisting of an identified inconsistency between subjective and actual value of startups, the present paper pursues the guiding question of how to assess the startup valuation primarily by means of a literature synthesis.

To address this research question, we proceed as follows in the remainder of the paper at hand: in Section 1, we summarize recent findings on how entrepreneurs/founders affect the valuation of their firms. Section 2 deals with the factor of innovation and how this influences the value of a company in general. Section 3 analyses governmental and social factors and their impact on the valuation of startup companies. In Section 4, we take a look at VC-backed companies, how VCs determine the valuation of a startup and how their presence influences the startups valuation. Next, we give three ideas on promising future research avenues. In the last section, our key findings are summarised.

2. Methodology

This paper establishes a systematic synthesis of the both academic and practice-oriented literature on the important, yet not consolidated topic of startup valuation which primarily takes place in the following four Sections 3 to 6. In Section 7, by contrast, emphasis is put on deriving lessons and an agenda for future research.

3. Impact factor 1: the entrepreneur’s influence on startup valuation

A primary factor that affects the valuation of a startup company is the question whether the startup’s founder is a serial entrepreneur (a person who has founded more than a single company) or not. According to Nahata (2019), companies founded by (previously successful) serial entrepreneurs receive higher valuations as well as equity purchase prices, which he gives two explanations for. Firstly, previously successful entrepreneurs might have a better negotiation power (“leverage”) over the VC, resulting in contracts in favour of the founder. Alternatively, due to “the importance of entrepreneurial effort which is further reinforced by their prior experience”, it seems only logical that venture capitalists offer previously unsuccessful founders encouragement in form of cash flow or control rights, while keeping the valuation low at the same time to compensate. However, Nahata found that previously unsuccessful serial entrepreneurs received better contracts from VCs than inexperienced founders did. Additionally, the study shows a positive correlation between startup valuations and the number of funding rounds, which is explained by the fact that successful IPOs are typically funded with higher valuations in later venture rounds. Another major finding of Nahata’s research is the fact that “serial founders are more likely to retain their CEO positions”, which also shows that the valuation depends on the prior experiences of the startup founder, and therefore need to be taken into account. However, it is important to mention that those findings have only been verified for VC-backed companies.

Matching with Nahata’s statements about the positive correlation between previously successful entrepreneurs and the “goodness” of their VC contracts, D.H. Hsu (2007) found that entrepreneurs with “successful previous founding experience are both more likely to receive VC funding through a direct tie and to have higher VC valuations”. The author also found that for companies within the (at the time of research) emerging internet industry, founding teams with a member holding a doctoral degree are more likely to get funded by VCs and also receive higher valuations, which the author explains by a “signal[l]ing effect to external resource providers”. Furthermore, the author found that “measures of human capital and social capital are positively related to venture valuation”.

According to Köhn (2018), the valuation of a startup company is positively influenced by the following factors: “having more than one founder, having a complete management team, previous startup experience, management and relevant industry experience, and also a higher level of education”, referring to D.H. Hsu (2007), Miloud et al. (2012), Sievers et al. (2013) and Wasserman (2017). However, other findings, such as those of Gompers et al. (2010) suggest that there is no evidence of serial entrepreneurs receiving higher valuations for their companies, as Köhn refers to it. In our opinion, this shows the importance of further verifying the results of the previous studies, as (as stated above), the results of Nahata (2019), for example, have only been verified for firms backed by VCs.

The findings of Faleye et al. (2020) suggest that especially smaller firms and R&D-intensive (such as biotech) or competitive industries (such as many B2C sectors) benefit from entrepreneurial-minded directors on their boards as they bring in valuable strategies on how to evolve in such fast-paced environments. The authors explain this by the “attributes, skills, and experiences” the entrepreneur brings into the firm. In our opinion, those findings can be transferred to startup valuation as well, as it shows that the entrepreneur himself has a large impact on the value of small and R&D-intensive firms – company characteristics that can be found especially in startup firms. For us, a verification of this hypothesis for the specific case of startup companies could be a substantial aspect of future research in this field. Faleye et al.’s findings further show that the concerns that “founder-managed firms perform better partly because entrepreneurs usually consider their firms as extensions of themselves and thus have a stronger intrinsic motivation to pursue value-enhancing strategies”, and that entrepreneurs are more likely to have significant firm-specific skills, do not hold. Rather, their results show that the value entrepreneur directors add, are derived “from their human capital rather than their special relations to the firms they found”. The similar conclusion by He (2008), furthermore, supports their findings. This shows that our assumptions made about the influence of entrepreneurs on the value of a firm holds, as it confirms that the entrepreneurial behaviour, rather than their status within the firm, is the reason for this effect. However, as we have already stated it, those results are just derived from a process of logical reasoning, instead of own empirical verification, which is why we think that an empirical analysis of reasons for the effect of value addition by entrepreneurs on the companies they found still needs to be verified for companies within the startup phase.

4. Impact factor 2: how innovation influences a company’s value

Research done by Nemlioglu and Mallick (2020) indicates that companies with a high degree of intellectual capital (IC) tended to outperform non-IC-intensive firms after the global financial crisis. Their research, furthermore, suggests that high research and development (R&D) activity, patents, advertising intensity and debt tend to increase the market valuation. Trademarks, however, only had a positive effect on the valuation of large firms. The authors also state that even though “leverage distorts market valuation for large […] firms, the impact is possible for SMEs [Small and medium-sized enterprises] that are innovation intensive”. According to Nemlioglu and Mallick, IC-intensive firms also seem to have higher market valuations in general, with lower uncertainty in those valuations, irrespective of their debt structure during economically bad times. In their study, the authors additionally investigated the “impact of sectoral heterogeneity on valuation and its uncertainty”. They did so by the three-sector classification (primary, secondary and tertiary) as well as “knowledge-intensive service sectors and high KIS [Knowledge intensive service sectors] with low-technology and low KIS sectors”. The findings of the first type of sectoral classification indicate that companies in the second sector tend to receive higher valuations if they “jointly focus on R&D and patenting along with debt”, while patents and R&D also contributes to higher valuations in the tertiary sector. With the second type of classification, Nemlioglu and Mallick found that high-tech manufacturing companies “benefit from patenting and R&D irrespective of their debt-intensity, whereas low- KIS firms benefit from trademark and advertising in general”. Furthermore, R&D and patents reduce the uncertainty in valuations, which is why the authors conclude that especially high-debt firms should focus on those aspects to reduce the valuation uncertainty. In their final conclusion, the authors state that high-tech firms achieve better valuations and are also able to reduce valuation uncertainties by patents and R&D investments, regardless of their debt level, while low-tech firms tend to profit more from trademark and advertising investments.

Jia (2018) refers to Sorescu and Spanjol (2008) by stating that an exploratory innovation strategy benefits shareholder “by increasing both profits and long-term abnormal returns”. Sorescu and Spanjol, furthermore, found that incremental innovations can help to preserve a company’s value, while breakthrough or disruptive innovations are “the key to achieving sustained long-term growth”. Jia (2018), however, states that the finding of his studies show that those “exploratory” innovations also bear the risk of extremely negative returns (including bankruptcy). He furthermore refers to Litov et al. (2012) by mentioning that the uniqueness of a company’s strategy is positively related to the firm’s value. We think that those findings can be transferred to startup companies, as they are commonly seen as innovative in their business models.

Wilson et al. (2018) state that for companies, involved in new technologies, innovations and a lack of tangible assets as securities, “classic valuation techniques are of little use”, referring to Manigart et al. (2000). As those information asymmetries might remain and result in problems with the company valuation, companies “at the later venture stage may face an equity funding gap” (Wilson et al., 2018).

In their study, Kwon and Lee (2019) present several findings about strategic determinants of high-tech company market valuations. As the authors also investigated those determinants for companies of different capacity levels, we think that their findings can be transferred to startup companies as well, due to their mostly innovative spirit. According to Kwon and Lee, two of the most impactful factors regarding a high-tech company’s market value are operational efficiency and corporate reputation. The authors therefore conclude that those results empirically prove “the conventional wisdom of harmonizing internal best practices and external attractiveness as a precondition for enhancing the market valuation of a firm”.

5. Impact factor 3: the influence of governmental and social factors on startup valuation

Questioning how governmental and social factors influence the valuation of startups, Berger and Köhn (2020) state that the valuation of startup firms that benefit, for example, from public, non-dilutive funds, is directly connected with the motivation of the entrepreneur, referring to Hsu et al. (2013) and Miloud et al. (2012). Furthermore, they mention that a link between the protection of VCs through formal institutions and investor uncertainty exists, i.e. the more VCs are protected the lower the uncertainty of investors, creating the basis for “high early-stage start-up valuations” and vice versa. Additionally, they mention that they consider startup valuation to be a “complex combination of different conditions of the institutional setting and a country’s innovativeness”, meaning that, for example, startups based in innovation-friendly countries should consequently be assigned a higher valuation. In support of this statement, Liu et al. (2019) state that “both the home country and the host country significantly affect foreign firms’ valuation and the success of their IPO”, referring to Bell et al. (2014). The authors also found that foreign (non-US) IPO firms with a higher entrepreneurial orientation receive significantly higher valuations. In our opinion, those findings can be transferred to startup valuation as well, as it shows that young companies with an entrepreneurial and therefore innovative approach are assigned higher valuations.

Although, government contractors have lower risk and therefore a lower cost of equity, which the authors explain by the more stable cash flows as an effect of the government as a main customer. Those more stable cashflows seem to weigh more heavily than “any increase in risk due to greater information asymmetry and agency costs” according to Esqueda et al. (2019). Esqueda et al. (2019) also found that companies, which are predominantly government contractors, tend to have lower valuations than firms without those government contracts. On the downside, however, firms that mainly sell their products to the government have a significantly lower sales growth, compared to other companies, which leads to the lower net valuation, as stated above. During recessions and industry downturns though, those lower valuations disappear “when the relative stability stemming from having a recession-proof counterparty compensates for the negatives”. Nevertheless, the overall lower valuations for government contractors is caused by strategically less important firms in this business, as the more important ones have significantly higher valuations. While they have a higher cost of equity, their overall performance is significantly higher, even regardless of the economic conditions as Esqueda et al. (2019) state. While startups, theoretically, might tender for government contract, there are still a number of obstacles that explain why some startups do not take this opportunity. Orazem et al. (2017), all of whom are in executive positions at Boston Consulting Group, state that in practice, startups generally seek to gain government contracts, although they are commonly deterred by, for example, a lengthy time for closing the contracts, complex processes, as well as a common assumption made by startups “that only established players with the right connections and sunk infrastructure have a chance of winning government work”.

According to findings made by Poczter and Shapsis (2018), there also seems to exist a gender disparity in startup valuation. The authors analysed the likelihood, as well as the valuation of startup teams to receive angel financing (early-stage financing by affluent individuals) and found that, depending on the industry, women-owned companies received valuations which, on average, were more than half a million US dollars below those of their male counterparts. Those findings, furthermore, suggested that “even a non-zero amount of women on entrepreneurial teams is associated with lower company valuations”. However, Poczter and Shapsis state that the lower valuations might be caused by their finding that entrepreneurial teams, which only consist of women, tend to ask for less funding themselves, suggesting that “limitations to funding may be partly self-imposed”.

Referring to Eccles et al. (2014), Lee (2012) and Nidumolu et al. (2013), Kwon and Lee (2019) state that environmental sustainability is becoming an essential indicator for “current performance and future potential of a firm” as it will enhance a company’s market valuation and competitiveness. However, the authors also state that even though it is generally perceived that environmental sustainability improves a firm’s performance and competitiveness, there is still some uncertainty regarding the relationship between sustainability and firm valuation. They furthermore refer to Trumpp and Guenther (2017) by mentioning that this uncertainty can be abstracted into two questions: “It pays to be green” or “It costs to be green” (cf. also Lăzăroiu et al., 2020).

As startup companies usually tend to be a more (socially minded/community oriented) environment, due to their more innovative character, we think that the question how corporate social responsibility (CSR) affects a firm’s valuation can be considered to be essential for valuing a startup company. According to Rjiba et al. (2020), other authors like Hillman and Keim (2001), Eccles et al. (2014), Fatemi et al. (2015), Ghoul et al. (2017) and Nguyen et al. (2020) have already established a positive relationship between CSR and corporate financial performance (CFP). Rjiba et al. state that this positive effect is caused by increased stakeholder engagement, resulting from a firm’s commitment to run a long-term relationship with its stakeholders. In their study, they additionally found that during times of high economic uncertainty, this positive valuation effect seems to be higher in developed markets.

6. Impact factor 4: how venture capitalists determine the value of a startup

According to Gornall and Strebulaev (2020), the analysis of VC-backed companies can be seen as rather difficult, as they differ substantially from debt or common stock being traded in financial markets, for example, because investors receive convertible preferred shares (which are better protected against the failure of a company, due to their seniority, and profit from the potential of converting them into common stocks in the case of the firms success). The authors also state that those shares issued to investors are profoundly different between companies and financing rounds, as the different share classes generally allow different rights over cashflows and control. Furthermore, Gornall and Strebulaev claim that the post-money valuation of a company (share price for the last financing round multiplied by the total number of shares outstanding), which is usually seen as the fair value of the firm, works for publicly traded companies with only one asset class, while it does not work for VC-backed companies, due to the different classes and financing rounds. Therefore, they conclude the fair value and the post-money valuation are not to be equated, although they cite Scott Kupor, partner of the venture capital firm Andreessen Horowitz, according to which “[s]ome venture firms value their companies by taking the last round company valuation in the private market and assigning that value to the VC firm’s ownership in that company”. This, again, shows the importance of our research question, as even some professional investors tend to simplify their valuations substantially.

Röhm et al. (2018) found that investment motivations of corporate venture capital (CVC) investors do not only influence their behaviour in the market for startup investments, but they are also a determinant of the valuation CVCs assign to startup companies. Their findings suggest that CVCs, which have a more strategic investment motivation tend to assign lower valuations to startup companies than analytically motivated CVCs which have moderate levels of the examined dimensions (financial and strategic) do. This suggests “that entrepreneurs trade off these CVCs’ value-adding contributions against a valuation discount”. Furthermore, the authors found that CVCs with an unfocused investment motivation (lack of a clearly defined investment motive) tend to pay purchase prices, which are significantly higher, “supporting the hypothesis that they have a so-called liability of vacillation”. By contrast, the valuations of financially motivated CVCs do not significantly differ from those of their analytically motivated counterparts.

According to Köhn (2018), “VCs assign higher valuations to ventures operating in highly differentiated industries and industries with higher growth rates”, referring to a study conducted by Miloud et al. (2012). Köhn, furthermore, refers to research undertaken by Davila et al. (2015), stating that VCs tend to assign a premium to startup companies, which adopt management control systems, “believing that they improve decision-making and execution”. This finding is underlined by Köhn’s reference to the study by Davila and Foster (2005) where a positive association between the early adoption of management accounting systems and valuations was found.

But also the competition among VCs seems to have an effect on the valuation of entrepreneurial enterprises. Colombo et al. (2019) state that in regions with higher competition among venture capitalists and a lower number of attractive firms, VCs tend to offer entrepreneurs a higher valuation, referring to Gompers and Lerner (2000).

7. Outlook and implications

8. Conclusion

With this paper, our goal was to summarise the current state of research about the valuation of startup companies. While some studies describe sound results about this topic, what we experienced during the research for this project was that many questions remain open or have not been covered at all. This is the reason why we needed to apply a substantial amount of reasoning in the analysis of studies that do not exactly deal with startup companies. In Section 7, we highlighted rather practical implications of our work. In terms of more theoretical contributions to the body of knowledge, we arrive at a mainly negative result: We doubt that at least a singular rigorous approach is suitable for assessing the capital value of startups, which is reinforced by the fact that heuristics and rules of thumb are actually applied in the economic practice.

Thereby, we hope that we have been able to provide some interesting impulses for future research in this exciting and growing research field with high practical relevance and, therefore, we are looking forward to new findings on this topic in the future.