Startup Saturday: Is your startup ‘worth’ it? Here’s the calculation
Tanwir Shirolkar, an independent chartered accountant, and Vaibhav Domkundwar, a seed-stage investor, explain how your startup will be valued by venture capitalists and why.Updated: Aug 19, 2018 16:29 IST
Tanwir Shirolkar, is an independent chartered accountant who works extensively in the field of valuations, joint ventures, and acquisitions. In fact, he is off to Japan to advise them on how to view joint ventures in India and recently, was part of the team that valued Flipkart. At a breakfast meet organised by TiE Pune, Tanwir explained how companies, particularly startups, are valued. Here are some insights:
How is valuation impacted? What are the factors?
Basically, the founders and the talent of the team are very important. Then, the product or idea or technology as the case may be. What stage is the product in? Alpha, beta, or is it functional? Is the technology disruptive? Is it easy to copy? What are the barriers? The higher the barriers, the greater the value of the technology. Is there a patent filed?
Then you have the market forces/state of the industry. A startup in a hot and fast-growing industry with huge potential for growth will have a much easier time validating its valuation than one entering a slow-growth sector.
What are the limitations of these approaches?
Income approach: Future cash flows are normally estimated from past results, but we do not have such history for startups. Estimating the future cash flow depends on lots of assumptions which are very judgmental. Further, it doesn’t account for time-varying risk profile of new ventures. DCF (discounted cash flows) also fails to capture value created by future managerial flexibility, whereby upside of opportunities can be seized and downsize of possibilities can be eliminated.
Market approach: It is challenging to find enough information about transactions of comparable companies for startups. It is difficult to include unique operating characteristics of the subject company or other distinctive values of its intangible assets in this approach. Also most of the time, startups may not have started generating revenue or profit and hence, applications of multiples become challenging.
Asset approach: Startups have no or little assets to start with, and most of their assets are in the form of intangibles, such as intellectual property, the value of which isn’t adequately reflected in the books.
What are the methods to value a company?
Basically, there are two approaches; traditional and the newer methods that have evolved over time.
The traditional methods:
1. Income approach: The income earning capacity/cash-generating capacity of a business is used to determine the value of the business. Common methods include discounted cash flow (DCF) and capitalised cash flow (CCF). The capitalisation of cash-flow method is most often used when a company is expected to have a relatively stable level of margins and growth in the future. The discounted cash flow method, on the other hand, is more flexible than the capitalisation of cash flow method and allows for variation in margins, growth rates, debt repayments, and other items in future years that may not remain static.
2. Market approach: The worth of a company is determined by comparing it to other similar companies. The comparable method uses ratios from an industry, peer group, or similar companies to estimate. Common methods include comparable transaction multiple and comparable company multiple. One can consider ratios like EBITDA multiple (valuation multiple used in the finance industry to measure the value of a company), sales multiple, PE (price-earning) multiple. There are other ratios also for typical industry, including number of beds for a hospital, assets under management for asset management company and plant capacity in a cement industry.
3. Asset approach: Common methods include net book value, adjusted net asset value, and replacement cost method.These methods work best for distressed or in-loss companies.The most commonly utilised asset-based approach to valuation is the adjusted net asset method. The balance sheet-focused method is used to value a company based on the difference between the fair market value of its assets and liabilities.
Newer methods of valuation:
Over the years, several unique methods have been devised to value startups. The amount of subjectivity in these methods is what differentiates them from traditional methods. New age methodologies to value startups are:
· Venture capital method
As the name implies, this method is mostly used by venture capitalists to value their startup ventures. Valuation is based on the return on investment expected by the investor. Future value can be determined by any methods including DCF or multiple method.
See the following example to understand the valuation. There is an angel investor who wants to invest Rs 5 lakhs in Year 0 in a startup with required rate of return of 50%
·First Chicago method
Valuation based on the probable long-term outcomes of the startup. You can have success, survival, or failure options. The success scenario is normally compliant with the business plan. Survival is based on less growth and delays in bringing the projects to completion, necessitating higher costs, while failure relates to a continuation of the status quo, or worse.
·Real option method
The method assumes that there is flexibility inherent in the operations of a startup and by valuing the flexibility, we can value the startup. For example, investment into a startup which is developing a technology or is into research and development. Normally, the investments are sequential ( such as stage of technology development, commercialisation, and market launch) and decision maker has options to abandon the project at certain points. Decisions are made in an uncertain environment and uncertainty decreases over a period of time as more information is available.
· Berkus method:
This is a very subjective method of valuation. Some value is given to each of the following parameters and then added to find the overall value:
• Sound idea
• Quality management team
• Strategic relationships
• Product roll-out or sales
Valuing an early-stage company is not a precise exercise. You will find a number of valuation methods and sooner or later, you will question yourself and which model considers all the relevant factors. Investors, hence, take weighted average of different methods (depending on the estimated fit of the model to the underlying business case) and create scenarios and probability matrix to decide the valuation.
Some of the questions that investors consider:
· How long will the growth last in the industry?
· Whether the external factors (regulatory, etc) impact market growth?
· Are consumers or users still excited about the market and how crowded is the market?
· What is unique about the startup which can shake-up the market?
· What are the barriers to entry?
Shareholding beyond certain threshold levels give shareholders some additional rights and controls. Therefore, such rights/control can result in a premium valuation for them.
Unlike listed entities, where the equities can be easily sold, stakes in private companies are not that easy to sell. Investment in startups entails a lock-in period of at least four to five years, thus making the investors’ investments not readily marketable. Quantification of the discount to apply due to lack of marketable can be subjective.
Skin in the game
Investors want to maximise their returns. They analyse what is the best way to exit. They evaluate what will be the cash burns in future for the startup to break even. They do backward calculations and analyse what range of dilutions will be acceptable to the founding partners.