Even though startup valuation is a complex subject, it boils down to two general approaches: a top-down approach and a bottom-up approach.
With a top-down approach, you can make the case for a valuation derived from addressable market size and expected market penetration. Or, 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 is offering pre-seed capital of $125,000 at 7%, which suggests a pre-money valuation of $1.6 million. You can use it as a reference for your own evaluation.
For startups with a financial history, you can use a bottom-up approach. Although you can use discounted cash flow (NPF) or other more sophisticated valuation methods, this is generally not necessary because most projects are valued based on a multiple of earnings.
How to choose the multiple to use?
Some companies sell at 25.30X EBITDA (earnings before interest, taxes, depreciation and amortization), others sell at 2.5X EBITDA.
For example, according to Equidam, companies in the coal industry sell for an average multiple of 4.53X EBITDA. Oil and Gas Exploration and Production isn’t far behind at 5.14X EBITDA.
On the other end of the spectrum, you have information services at 25.30X EBITDA and software companies which are valued at a multiple of 24.35X EBITDA.
Why are investors willing to pay such a premium to acquire certain companies and not the others?
To answer this question, you need to understand that a higher valuation (i.e. higher earnings multiple) simply represents higher expectations on the part of investors for future growth of the company . The main reason a software company can be expected to grow much more than a coal company is innovation.
A software business is highly scalable. Its marginal costs (cost per additional unit of output) are low and, if it can innovate and create unique value in the market, it could grow quickly and become a leader in its own market niche.
Additionally, the IT industry is historically very new compared to, say, coal or oil and gas, meaning there are more opportunities for innovation as technology continues to develop rapidly, a good example being blockchain technology, which followed the Web 2.0 revolution, etc. .
In summary, innovation is the primary reason for high valuation multiples, as investors are willing to pay a premium for companies that have an opportunity to grow quickly while potentially creating a defensible solution.
From risk and opportunity are the main drivers of growth for any project, innovative projects are simply much more likely to develop than non-innovative projects. Therefore, investing in innovation could be the best thing you can do if you want to significantly increase the value of your business.