How important is flexibility in valuation models for startups operating in uncertain markets?

In recent times, the share prices of US companies, private as well as public, have been extremely volatile due to inflation, interest rate uncertainty, and tariffs. Such factors that affect all companies across industries are collectively referred to as market conditions. Investing in uncertain markets can be extremely risky, yet extremely rewarding. 

In such periods, high-value companies are likely to trade at attractive discounts. However, market conditions can be extremely unpredictable, and hence, understanding which valuation would be a good entry point is also challenging. 

In this article, we shall discuss how you can navigate uncertain markets to maximize gains while accounting for all risks.

Types of market uncertainties and how they impact startup valuations

Some types of market uncertainties that can impact startup valuations and hinder investment decision-making are as follows:

1. Regulatory uncertainties

Most startups can be categorized as disruptors and frontier tech startups. While disruptors aim to displace incumbents in existing value chains, frontier tech startups introduce entirely new products for needs that have been largely unaddressed. Since frontier tech startups have novel technologies and business models, their impact on the business environment, industry dynamics, market competition, and ultimately, human lives is difficult to predict. Hence, such startups are exposed to a great deal of regulatory uncertainty.

Depending on the governance style, political beliefs, and campaign promises of the ruling party, the regulatory response could either extremely restrict operations of such startups or provide them free rein. In these completely contrasting scenarios, the valuations of such startups are likely to be extremely different.

2. Economic uncertainties

Macroeconomic factors such as gross domestic product (GDP) growth rate, consumption expenditure, interest rates, inflation, and unemployment rate impact all businesses. They determine the ease with which a business can generate revenue or raise funds. However, due to disruptions in certain industries, supply chains, or asset markets, macroeconomic conditions can take a turn for the worse.

Recently, the US economy was plagued by the risk of a recession and sustained high inflation, which would have discouraged consumers from spending. At the same time, if inflation had gone out of control, the Federal Reserve would have been forced to persist longer with higher interest rates, which would also make it more expensive to borrow.

Thus, economic uncertainty can introduce ambiguity in startup valuations.

3. Value chain disruptions

Just as a startup may attempt to displace incumbents, they themselves can face disruptions from newer entrants targeting the same role or a broader role in the value chain.  The development of new technology or business models may threaten the existence of a startup. At the very least, it can change the competitive dynamics for the startup in question. In order to protect its market share, the startup may need to match the offerings of its new competitors, which may require an influx of talent or capital expenditure.

Thus, value chain disruptions can change a startup’s cost economics and funding requirements, thereby changing its overall valuation.

Indirect value chain disruptions can also shift a company’s valuation. An example of this would be consolidation among upstream suppliers or downstream buyers, which can reduce a startup’s pricing power. When this happens, the startup’s costs will increase or its revenue will reduce, ultimately reducing the valuation.

4. Geopolitical events

Geopolitical events such as wars, trade disputes, and breakdown or formation of trade unions, free trade agreements, and economic unions can have wide-ranging impacts. Such events do not just impact the wider macroeconomic trends but can also shift government stances. As a result, industries may have to adapt to new regulations due to geopolitical events. 

If a startup relies on imports or exports its product to other countries, geopolitical disruptions will change its cost structure and revenue generation capability. It will impact who they can do business with and the taxes and tariffs they are subjected to.

Role of flexible valuation models in navigating uncertainty

The best perspective for understanding the importance of flexibility in valuation models is the investor’s perspective. Before becoming an insider, an investor will have limited information and may have to make sense of market uncertainties to make a decision on whether to invest or not. 

A flexible valuation model allows them to account for these uncertainties and aims to converge on the startup’s true value as market conditions become clearer.

Let us consider a simple scenario where market uncertainties impact the expected returns by the investor and the expected growth rate. So, assume that you have a choice on whether to invest $1 million into Nouvo Circle, a gaming startup, and the key valuation parameters have the following ranges.

1. Expected return based on market performance: 12% to 16%
2. Expected EBITDA growth rate: 20% to 40%
3. Expected life: 5 years
4. Annual growth of capital expenditure: 6%
5. Annual reduction in net working capital: 28%
6. Annual growth in depreciation and amortization: 4%

Finally, let us also assume that you also have access to the following financial history.

Based on this information, you can generate the following projections using the discounted cash flow valuation method.

So, in the negotiations, you can accept a maximum pre-money valuation of $3.17 million, and anything below $1.78 million would be a discount. Furthermore, when the markets stabilize, and the EBITDA growth rate also becomes clearer through further research, you can narrow down on the ideal pre-money valuation. This will ensure that your entry valuation is not too high.

Empowering investors with data-driven valuation insights!

To truly leverage the power of flexible valuation models, you must base your assumptions on expert opinions on market outlooks. Most major financial institutions and regulatory bodies regularly publish macroeconomic forecasts for countries, regions, and the global economy. 

Thus, research on macroeconomic variables is easily accessible. However, challenges arise when you need to account for uncertainty in industry-specific trends, geopolitical risks, or other underreported factors.

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