Startups vs. Small Businesses

Understanding Differences and Valuation Techniques

7/3/20232 min read

startup, sme, business
startup, sme, business

The terms "startup" and "small business" are often used interchangeably, but they represent fundamentally different types of businesses with distinct strategies and objectives. If you're considering launching a venture, it's crucial to understand these differences and the type of business you're aiming to build.

Startups, as defined by renowned startup incubator Y Combinator, are companies designed for rapid growth. They often bring novel ideas to the table, with the potential to capture a large market share and disrupt an industry. Tech companies like Airbnb and Uber are classic examples of startups, as they had innovative ideas and the potential for rapid expansion. Startups often aim to disrupt their industry, like Slack's ambition to revolutionize workplace communications or Grubhub's goal to simplify food ordering.

On the other hand, small businesses don't necessarily aim for rapid growth or industry disruption. Their goal is to identify a market, reach it effectively, and generate revenue. The US Small Business Administration (SBA) defines a small business as a for-profit, independently owned and operated business that doesn't have national or international reach. Examples include local bookshops, pet stores, and boutique interior design firms.

The distinction between startups and small businesses extends to their growth intentions, funding, and long-term objectives. Startups are characterized by their intention to grow rapidly, often requiring substantial capital investment before turning a profit. In contrast, the success of a small business is less tied to growth and more to consistent profitability.

Valuing a startup, particularly one with little or no revenue or profits, can be challenging. Traditional methods of valuation, such as multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA), may not apply. Instead, several other methods can be used to value startups.

The cost-to-duplicate method calculates how much it would cost to build another company just like it from scratch. The market multiple approach values the company against recent acquisitions of similar companies in the market. The discounted cash flow (DCF) analysis forecasts the company's future cash flow and calculates its present value. Lastly, the valuation by stage approach assigns a rough value to the company based on its stage of commercial development.

However, these methods come with their own challenges. Startups often lack historical financial information, making it difficult to evaluate their performance. Predicting their future growth can be challenging due to rapidly changing marketplaces. Furthermore, startups often propose groundbreaking technologies or unique business strategies that lack proven standards or comparables, making it difficult to find similar businesses for valuation purposes.

In conclusion, startups and small businesses are distinct types of ventures with different growth intentions, funding methods, and long-term objectives. Valuing startups can be complex and requires the use of specific methods. Understanding these differences and valuation techniques is crucial for entrepreneurs and investors alike.