Why are Silicon Valley valuations higher?

“Are you a tech startup based in the US, preferably Silicon Valley?”

If yes, then all bets are off for the business valuation you can achieve. Even in this environment of higher interest rates and more conservatism in general, the culture of Silicon Valley and the resultant deals mean that business valuations can be eye-wateringly high. There are good reasons for this, which we will touch on in this article.

Beyond Silicon Valley, things are somewhat less crazy. Valuations of fast-growing companies can still be difficult to understand, but there are sensible methodologies that can demonstrate why today’s numbers aren’t the best indication of value. Like in the Silicon Valley example, there are good reasons for this.

Clearly, the right way to answer the question of how to value a startup will start with “where is your startup based?”

Business value is mostly derived from growth

The difference between fixed income investments (like government bonds) and equity investments (like stocks listed on a stock exchange) is that investors in the latter are seeking growth in the underlying cash flows. If this growth rate is higher than inflation, this is called “real growth” and it means that there is genuine wealth creation over time. The extent to which the returns must exceed inflation in order to attract investors will depend on the riskiness of the investment. The risk drives the required returns, not the other way around.

In startups, the risk factors are through the roof. Most of them are still making losses, so the economic viability hasn’t been proven yet. There are endless risks of possible disruption to the plan, or key staff members leaving. If funding dries up at a critical stage, then it can all go to zero even if the founders did everything right along the way.

Long story short: for startups to be valuable, they need to be able to grow at great pace. The environment in which they operate will be one of the biggest determinants of that growth rate. No matter how great the founders are, swimming downstream is so much easier than swimming upstream. Any business valuation calculator for a startup will make this a primary input.

Valley of dreams

Despite efforts by many local and national governments to set up startup hubs beyond the coffee shops of Silicon Valley, nothing has yet matched the level of activity in the home of technology.

This has an immense flywheel effect on growth:

• Businesses are built on opportunity sets and the connections made that turn ideas into operations. If there are more entrepreneurs in a specific area, then this breeds not just heightened competition, but also the potential for value-adding collaborations.
• The network of funders and mentors in startup hotbeds cannot be matched by more outlying areas, with founders able to build alongside people rather than in isolation from them.
• Potential acquirers are more likely to search for technology acquisitions in areas that are hives of activity, maximising the chance of an exit down the line.
• Highly talented potential staff members looking for work in startups will be naturally drawn to areas where the chance of getting a job is higher, so founders in these areas can add excellent resources to their businesses without much effort.

Of course, this isn’t to say that Silicon Valley is the only place where a founder can be successful. Far from it, actually. This isn’t an on/off switch. Think of it more as a spectrum, with Silicon Valley at one end and completely unknown jurisdictions at the other. Along that spectrum, there are various other well-respected cities and regions that can attract investment in startups, including the likes of London or Berlin.

The startup valuations in different regions will reflect this spectrum. Investors are far more likely to pay up for a business that is operating in the perfect ecosystem vs. one that comes with compromises. This isn’t snobbery; it’s simple the maths of the growth potential and what this means for the valuation today.

Of course, founders shouldn’t forget that this wonderful ecosystem comes with costs. A top developer in Silicon Valley will demand a much higher salary than a developer in Cape Town. The cost of living is much higher for all involved. This makes every cost in the business more onerous, ranging from rent through to accounting services.

Although the startup valuation multiple for a startup in Silicon Valley will almost certainly be higher than a similar business in other regions, that doesn’t mean that the cash burn along the way will be easier to manage. If anything, it’s probably harder.

This is why the startup funding cycles drive exaggerated outcomes in Silicon Valley and other hotspots. When money is available, founders must be eternal optimists and must scale at all costs to compete for funding. When the belts are tightened, layoffs are the only outcome as founders cut back the fat to show funders that there’s a cash flow positive business in there somewhere.

Where funding is less easily available, founders follow more of a bootstrap mentality. This leads to more measured responses to economic cycles, which is typical of what you’ll see among founders outside of Silicon Valley.

A big fish must find a bigger pond

Thankfully, startups don’t need to only earn revenue from the city in which they were founded. In the global village, it is possible (and practically a prerequisite) for startups to expand into new markets and offer their services or products.

This is the best way for a startup in a more unusual region to create a great deal of value. By operating outside the main hotbeds, they can get away with a much lower cost structure. Although the surrounding ecosystem may not be as conducive to growth, there’s also less competition for talent and for funding. To truly take advantage of this, the low cost base needs to be used to deliver products to a global audience.

There are plenty of examples of startups that were built outside of Silicon Valley – and even the US. Xero accounting is probably a brand that you recognise. What you might not know is that the company was founded in 2006 in Wellington, New Zealand.

Canva is a brand that is loved by founders, allowing just about anyone to put together decent-looking graphics. It was founded in Perth, Australia in January 2013.

There are of course numerous other startups that have made it from places that are nowhere near Silicon Valley. It’s just helpful to use Australian and New Zealand examples as extreme distances from Silicon Valley.

In closing

• You can build from just about anywhere, but make sure you’re building something that can scale to a global audience if you hope to achieve a large startup valuation.
• Positioning yourself in a startup friendly ecosystem is likely to give your startup valuation a boost – plus you’ll have a stronger chance of meeting the right people.
• Think about the pros and cons of each potential home for your startup carefully, as a more popular environment might mean that finding the right team members is easier, but you’ll probably need to pay more.

The Finance Ghost is a co-founder of bizval, where the team is dedicated to making valuation services accessible and affordable for smaller businesses and startups. Visit the bizval website to learn more.

This article was first published on the bizval website here.