Understanding the relationship between innovation and startup valuation

Startup valuation, more often than not, comes down to the two general approaches — a top-down or a bottom-up approach.

The top-down approach helps you calculate the value of your startup based on addressable market size and expected market penetration or the pre/post-money valuation of similar companies. 

On the other hand, startups with an established financial history can use a bottom-up approach and employ discounted cash flows or other more sophisticated valuation methods. Or, they can simply stick to the EBITDA multiple to estimate the value of their business.

But when it comes to selling or funding, even valuations based on EBITDA use different multiples for companies from different industries, wherein some are valued 25 times EBITDA and many others sell for only 2.5 times EBITDA. For instance, businesses in the coal industry sell for an average multiple of 5.59 X EBITDA while software companies are valued with a 30.92 X EBITDA multiple, as per November 2021 data from Equidam. 

This brings us to the question — why are investors willing to pay a premium to acquire some businesses and not others? It’s because they look for innovators.

Investors are most attracted to companies that employ new technology and are constantly looking for ways to reduce costs, improve performance and boost profits. Hence, a higher valuation (i.e., higher earnings multiple) renders investors’ higher expectations for future earning potential and growth of the business.

Decoding the innovation-valuation relationship

In light of the above, high valuation multiples for software companies would imply higher growth expectations. But why is it that software firms are expected to grow much more than businesses in the coal industry? The key reason is innovation. 

A software company is highly scalable. It has considerably lower marginal costs, and if it can innovate and come up with cost-effective methods and processes, and create unique value in the market, it is likely to grow rapidly and become a market leader in its niche. Further, the IT industry is very new in comparison to coal or oil and gas. This means there are more opportunities for innovation as the technology is still developing.

In a nutshell, the value of your startup is directly linked to your ability to innovate, adapt and thrive in an ever-changing world. 

Recap 

Innovation is the key reason behind the high valuation multiples investors are willing to pay for companies that promise fast growth while potentially building a defensible business solution.

Better said, as innovative companies are almost always more valuable, embracing innovation could be the best thing you can do if you want to significantly amp up the value of your business.