The Enforcement Directorate (ED) raid at investor Sequoia Capital office in Bengaluru on April 18 in connection with a minority investment in Chennai-based Vasan Healthcare has raised a billion-dollar question on ED’s understanding of valuation mechanisms of the venture capital (VC) funds.
Sequoia invested Rs 50 crore in Vasan Healthcare in February 2009, and Sequoia in October 2010 reached out to Advantage Strategic Consulting Pvt. Ltd—a firm in which Karti Chidambaram, son of former finance minister P Chidambaram, was director —to buy out its equity stake in the company.
Advantage sold a partial stake (30,000 of the 150,000 shares it held in the company) to Sequoia at a massive Rs 7,500 per share—a significant premium, considering that Advantage had acquired the shares at Rs 100 apiece.
So the question is, “how can shares bought in a non-listed business for Rs 100 a piece be sold for Rs 7,500? But that would only cover part of the territory.
The bigger question that should be asked is - do investigating agencies really understand this apparent madness in the VC world?
This article is not about justifying the valuation of the shares in this deal. This is not even about whether the ED must take a magnifying glass to the deal.
But to doubt a deal just because the numbers involved don’t make apparent sense, may be contrary to the logic of VC investors, which may appear nonsense to so-called ‘lay people’.
HT spoke to a few experts, and this is what they have to say.
Venture capitalists invest much ahead of the market. Thus, conventional valuation methods such as net-worth, or market price (read price-earning ratio or private equity) do not come into play here. The private equity (PE) is a time-tested metric, which shows how many times the company’s earnings is paid as the market price. This means if the earning per share is Rs 10 and the market price of the stock is Rs 15, the PE would be 1.5x.
But venture capitalists are dealing with unlisted companies, which have no market price and do not make any profits.
Bengaluru-based Vaitheeswaran Kothandaraman, who co-founded India’s first e-commerce company Fabmart.com (later branded Indiaplaza), and also co-founded India’s first integrated retail company Fabmall, which was acquired by Aditya Birla Group in 2006 and re-branded as “More”, said the venture capitalists takes a call on the basis of the growth potential of the business.
“This is easy to prove in a market like India where the population is 1.3 billion, and even a small percentage of this will translate into a large number, however silly it may look.”
The frantic chase by e-commerce companies such as Flipkart, Snapdeal or Ola and Uber to show more loyal customers is a good example of this logic.
A private startup investor, who did not wish to be identified, said: “Why the price moved up by 10 times in two years is again not surprising, and by itself does not mean anything. In the life cycle of a startup, two years is a long time. In almost every ‘hot sector’ such gains have been there. Take the case of Flipkart, Snapdeal or Ola -- their financing rounds have been even steeper valuation increases in a shorter period of time.”
a. Ola went from $200-250 million valuation to $2.5-4.5 billion – all within two to three year period. The last valuation jump came within a few months.
b. Flipkart went from $1 billion valuation, to $3 billion, then $7 billion, then $11 billion valuation and then to $15 billion – all within two years. This is a 15 times increase in two years. Recently, this was devalued by one investor Morgan Stanley by 27% to $11 billion
c.Snapdeal was at $250 million valuation and then jumped to $1 billion and then to $6 billion in quick succession.
“Startup valuation and what is ‘fair market value’ of an unlisted company is completely non-deterministic. It depends on several factors – market dominance and leadership, future of the sector, core platform, or technology, and how it will create future barrier to entry of other players, first mover advantage, next 10 to 20 years market scenario , the perception about its sustainability, herd mentality of investors etc,” the investor added. “Some of these are measurable and quantifiable, but most of them are subjective, and will depend on the whims and fancy of the investor and their mood at that point of time. Thus, trying to compare the valuation of a startup and how it can be valued differently in two years’ time is ridiculous, and shows people don’t understand how a startup is valued. This is not like real estate where the land prices or guidance value creeps up more predictably or in an arithmetic progression.”
Kothandaraman agrees, saying three significant factors come to play – does the business enjoy a significant advantage over the competition, does it have a magic sauce, and does it have an ace team that can execute plans and strategies to perfection. “Fundamentally, it is not scientific. We may wish it was but it is not. In the absence of science, it becomes an art,” he said.
Padmaja Ruparel, president of Indian Angel Network, which is one of the most-successful investing groups, both in India and abroad, said the s look at the future value of the business. “There is no standard formula. You can apply as many formulae as you wish, but there are so many uncontrollable factors,” said Ruparel.
Timing of the investment also plays a crucial role in the valuation of a business. The venture capitalists typically work on a five-to-ten year investment cycle. They have to show a good return on investment to their investors. On their own investment timeline, the later they invest, higher will be the valuation, and therefore higher risk. “Not deploying the money is the worst they can do,” said Kothandaraman.
He added fear and greed also have a big role to play. “This is like the Diwali offers, when you hear buy 3 shirts and get 7 free, before the offer closes. You may not need 10 shirts, but you still end up buying them,” he said.
Given the size of the investments and the high risks they come with, the venture capitalists function democratically and in most cases to a fault. Investment committees comprising experts in the sectors decide whether to invest or not.
“In many cases, even the majority opinion won’t count. All must agree to invest,” said Kothandaraman.
For every such jump and investor, putting money at high valuations – there are enough naysayers and other investors who don’t believe in the valuations. That is the very nature of the unlisted company valuations, especially of the new-age companies, which are creating a new sector or a category.
“Vasan (Healthcare) was one of the first organised, retail, small footprint chains with a great business model that had been proven. Thus, some investors who like the model and want to bet on the sector and macro factors can easily value it at multiple of what it was valued two years back,” said one millionaire investor with a track record of several successful exits in the past.