How to value startups

On the occasion of the first National Startup Day, let us take a look at how startups are valued.

Background

By its very nature, valuation is highly subjective. For instance, let us consider the world-famous painting of Mona Lisa. The painting is worth billions for some whereas others may consider it as an average piece of work. Therein lies the beauty of valuation; it is in the eyes of the beholder.

The three most common globally accepted methods of valuing a business are tabulated below for ease of understanding:

1. Income approach

Popularly known as the Discounted Cash Flow (DCF) method. In this approach, estimated cash flows for the foreseeable future are discounted to present value and business is valued accordingly.

2. Asset approach

This approach is generally used when the business is not a going concern viz. during liquidation, untimely losses etc. The assets and liabilities are valued based on their current realisable value and that is considered as value of the business

3. Market approach

This approach assigns the value of a business based on the value of comparable companies in same/ similar industries, adjusted for their specific parameters.

These methods have been used in valuation of businesses since decades and have been accepted by businessmen, lawmakers, Courts and investors alike.

However, one common feature in the above approaches is that it pre-supposes a business which is established and generating cash flows using its assets.

Start-ups, by their very definition, are disruptors. They disrupt industries, products, processes using innovative means. It is difficult to call them “established” in any sense or assume that their cash flows (if not already spent on marketing) will remain constant. Profitability seems to be a cursed word in the start-up investor circles.

As we will explore later in this article, the traditional methods find themselves inadequate to arrive at the value of a new age start-up.

With the dawn of the 21stcentury, new methods have emerged which attempt to find the true value of a start-up. But a good valuer understands that the actual value lies less in the numbers and more in the story of the start-up.

In this article, we look at the basics of valuing any business and how to go about valuing a new age start-up.

Valuation of start-ups

The valuation of start-ups is often required for bringing in investments either by way of equity or debt. The biggest differentiating factor in valuation of a start-up is that there is no historical data available on the basis of which future projections can be drawn.

The value rests entirely on its future growth potential, which, in many cases is based on an untested idea and may not have been based on adequate sampling of consumer behaviour or anticipated consumer behaviour. The estimates of future growth are also often based upon assessments of the competence, drive, and self-belief of, at times, very highly qualified and intelligent managers and their capacity to convert a promising idea into commercial success.

The major roadblock with start-up valuation is the absence of past performance indicators. There is no ‘past’ track record, only a future whose narrative is controlled based on the skills of the founders. It can be equated as founders walking in the dark and making the investors believe that they are wearing night vision goggles. While this is exciting and fun for the founders, this is risky for the investors.

This is why valuation of start-ups becomes critical and the role of a professional comes in – it is a way of definitively helping investors navigate the dark using facts, rather than fairy tales.

Why traditional methods cannot be applied?

Each of the commonly used methods discussed above pre-suppose an established business – which is profitable, has established competitors and generates cash using its assets.

However, this is missing in new age start-ups whose value can lie majorly in the concept and potential, rather than numbers with a track record.

The failure of each of the traditional methods in case of new age start-ups is tabulated below:

1. Income approach

A vast majority of start-ups operate under the assumption of not generating positive cash flows in the foreseeable future. Off late, this business model has been accepted and normalised by the investor community as well. Since there are no or minimal positive cash flows, it is difficult to correctly value the business.

2. Asset approach

There are two reasons why this approach does not work for new age start-ups:

- Start-ups have negligible assets – a large chunk of their assets are in form of intellectual property and other intangible assets. Valuing them correctly is a challenge and arriving at a consensus with investors is even more difficult.

- Start-ups are new but they normally operate under the going concern assumption; hence their value should not be limited to the realisable value of assets today.

3. Market approach

New age start-ups are disruptors. They generally function in a market without established competitors. Their competition is from other start-ups functioning in the same genre. Lack of established competitors indicates that their numbers may be skewed and not be comparable enough to form a base. However, out of the three traditional approaches, we have seen few elements of the market approach being used for valuing new age start-ups as well, especially during advanced funding rounds.

As we have discussed above, the traditional methods fall short in recognising true value to new age start-ups. The inherent question that arises is what methods should we use for valuing new age start-ups. To understand that, we have to see what factors drive their value (no prizes for guessing – profitability is not one of them).

Value Drivers for start-ups

While every start-up can be vastly different, we now take a look at few key value drivers and their impact on the valuation of a start-up.

Product

The uniqueness and readiness of the product or service offered by the start-up creates a large impact on the valuation of the company. A company which is ready with a fully functional product (or prototype) or service offering will attract higher value than one whose offering is still an ‘idea’. Further, market testing and customer response are key sub-drivers to gauge how good the product is.

Management

More than half of Indian unicorn start-ups have founders from IIT or IIM. While it may seem unfair prima facie, it is a fact that if the founders are educated from elite schools and colleges, the start-up is looked upon more favourably by the investors and stakeholders alike. Accordingly, it is imperative to consider the credentials and balance of the management. For instance, a team with engineers is not as well balanced as a team comprising of engineers, finance professionals, MBA graduates. Keeping aside the obvious subjectivity in evaluating the management, the profile of the owners plays a key role in valuing the start-up.

Traction

Traction is quantifiable evidence that the product or service works and there is a demand for it. The better the traction, the more valuable will be the start-up.

Revenue

The more the revenue streams, the more valuable the company. While revenues are not mandatory, their existence is a better indicator than merely demonstrating traction and makes the start-up more valuable.

Industry attractiveness

The industry attractiveness plays a key role in the value of a company. As good as the idea may be, in order to sustainably scale, various factors like logistics, distribution channels, customer base have a significant impact on the value of the start-up.

For example, a new age start-up in the tourism industry will be less valuable, as innovative or unique their offering is, if significant lockdowns are expected in the future.

Demand - supply

If the industry is attractive, there will be more demand from investors which make the individual companies in the industry much more valuable.

Competitiveness

The lesser the competitors, the more valuable the start-up will be. There is no escaping the first mover advantage in any industry. While it is easier to convince the investors about a business which already exists (for example, it must have been easier for an Ola to convince investors when Uber was already running successfully), it also casts an additional burden on the start-up to differentiate itself from competition.

Methods for valuing start-ups

One key observation would be that most value drivers described above are highly subjective. Hence, there is a need for providing standard methods using value drivers above in order to value the start-up in a manner comparable to others.

There are many innovative methods for valuing start-ups which try to reduce the subjectivity in valuation of start-ups which have come in the recent times.

Let us take a look at the most common methods of valuing start-ups:

1. Berkus Approach

The Berkus Approach, created by American venture capitalist and angel investor Dave Berkus, looks at valuing a start-up enterprise based on a detailed assessment of five key success factors:

(1) Basic value,

(2) Technology,

(3) Execution,

(4) Strategic relationships in its core market, and

(5) Production and consequent sales.

A detailed assessment is carried out evaluating how much value the five key success factors in quantitative measure add up to the total value of the enterprise. Based on these numbers, the start-up is valued.

This method caps pre-revenue valuations at $2 million and post-revenue valuations at $2.5 million. Although it doesn’t take other market factors into account, the limited scope is useful for businesses looking for an uncomplicated tool.

2. Cost-to-Duplicate Approach

The Cost-to-Duplicate Approach involves taking into account all costs and expenses associated with the start-up and the development of its product, including the purchase of its physical assets. All such expenses are taken into account in order to determine the start-up’s fair market value based on all the expenses. This approach is often criticised for not focusing on the future revenue projections or the assets of the start-up.

3. Comparable Transactions Method

Coming close to the traditional market approach, this approach is lucrative for investors because it is built on precedent. The question being answered is, “How much were similar start-ups valued at?”

For instance, imagine that XYZ Ltd, a logistics start-up, was acquired for Rs 560 crores. It had 24 crore active users. That’s roughly Rs 23 per user.

Suppose you are valuing ABC Ltd which is another logistics start-up with 1.75 crore users. That gives ABC Ltd a valuation of about Rs 40 crores under this method.

With any comparison model, one needs to factor in ratios or multipliers for anything that is a differentiating factor. Examples would be proprietary technologies, intangibles, industry penetration, locational advantages etc. Depending on the same, the multiplier may be adjusted.

4. Scorecard Valuation Method

The Scorecard Method is another option for pre-revenue businesses. It also works by comparing the start-up to others that are already funded but with added criteria.

First, we find the average pre-money valuation of comparable companies. Then, we consider how the business stacks up according to the following qualities.

· Strength of the team: 0-30%

· Size of the opportunity: 0-25%

· Product or service: 0-15%

· Competitive environment: 0-10%

· Marketing, sales channels, and partnerships: 0-10%

· Need for additional investment: 0-5%

· Others: 0-5%

Then we assign each quality a comparison percentage. Essentially, it can be on par (100%), below average (<100%), or above average (>100%) for each quality compared to competitors/ industry. For example, the marketing team a 150% score because it is fully trained and has tested a customer base which has positively responded. You’d multiply 10% by 150% to get a factor of .15.

This exercise is undertaken for each start-up quality and the sum of all factors is computed. Finally, that sum is multiplied by the average valuation in the business sector to get pre-revenue valuation.

5. First Chicago Method

This method combines a Discounted Cash Flow approach and market approach to give a fair estimate of start-up value. It works out

• Worst-case scenario

• Normal case scenario

• Best-case scenario

Valuation is done for each of these situations and finally multiplied with a probability factor to arrive at a weighted average value.

6. Venture Capital Method

As the name suggests, this method has been made famous by venture capital firms. Such investors seek a return equal to some multiple of their initial investment or will seek to achieve a specific internal rate of return based upon the level of risk they perceive in the venture.

The method incorporates this understanding and uses the relevant time frame in discounting a future value attributable to the firm.

The post-money value is calculated by discounting the rate that represents an investor’s expected or required rate of return.

The investor seeks a return based on some multiple of their initial investment. For example, the investor may seek a return of 10x, 20x, 30x, etc., their original investment at the time of exit.

Rising above numbers – The Story

An article about valuation about start-ups cannot be complete without understanding the importance of storytelling in valuation journey.

Professor Aswath Damodaran, widely regarded as the Dean of valuation, puts forth “If all you have are numbers on a spreadsheet, you don’t have valuation, you just have a collection of numbers.”

Let us attempt to understand the importance of stories in valuation by way of an example of valuing the shares of Rolex. We will attempt to value Rolex in three scenarios and the reader may assume the role of an investor on the verge of making an investment decision.

Scenario 1 - The earnings of Rolex are slated to grow at 9.5% for the next 8 years before dropping down to the GDP growth rate; the Operating Profit Margin will be 43%, the Net Profit Margin will be 16% and it will be able to generate Rs 2.54 for every rupee invested in the business.

Scenario 2 – Rolex is a manufacturer of luxury watches that can charge astronomically high prices for its watches, earn huge profit margins due to scarcity of luxury watches available to an exclusive club of wealthy individuals.

Scenario 3 – Due to the need to maintain its exclusivity, the revenues of Rolex will grow at a low rate of 9.5% for the next 5 years. The same need for exclusivity also allows Rolex to earn an above-average operating margin and maintain stable earnings over time because the client base of Rolex is relatively unaffected by the highs and lows of the economy.

As the reader would notice, Scenario 1 deals exclusively with the numbers whereas scenario 2 deals with the story. Scenario 1 will not inspire an investor but scenario 2 will not help the investor reach a conclusion either.

It is only in scenario 3 where the value of the business is derived by tying the numbers to the story of the company. Here, the numbers get a backing and are easier to understand for the potential investor. Merging story-telling with the numbers is the real hallmark of a good valuation.

Prof. Aswath Damodaran has laid down a brief five-step process for integrating story into numbers. The same is explained below:

Valuation of start-ups – A cocktail

Nobody knows what the future holds and valuers are not astrologers, though their success is largely measured by how well they can predict the future.

It is said that valuation by itself is a combination of science and art. The author has a unique take – valuation is a scientific art. It is an art constructed by the valuer yet there is a definite method in the madness. The sanctity of a valuation is preserved by being able to back up the numbers using logical numbers, narratives and assumptions.

New age start-ups are disruptors in their own right and a necessary tool for global innovation and progress. By their very nature, start-ups disrupt set processes and industries in order to add value. In that process, they transcend traditional indicators of success like revenues, profitability, asset size etc. Accordingly, it is no lean feat to uncover the true value of a start-up.

While the traditional methods fall short, there is no dearth of new innovative methods used to value start-ups based on their value drivers. However, valuation of a start-up is much more than application of methods – it is about understanding the story of the future trajectory and being able to communicate that narrative using tangible numbers.

A good valuation of a start-up is a cocktail of the story and the numbers which can help the investors make informed decisions to navigate the uncertainty of the future.

We would love to hear from you. Do reach out to us at contact@vprpca.com