July 2019

VALUATION OF STARTUPS

Lata R. Gujar More
Chartered Accountant

Generally, the valuation approaches or methodologies are based on the evaluation of assets, revenue, profitability, etc. of the business. However, in case of startups, they neither have an asset base nor revenue. For example, the valuation of Airbnb is over twice as much as that of Hyatt – although Airbnb is effectively the world’s largest hotel chain without owning a single hotel room! Hence, the exercise of valuing a startup poses various challenges to the valuer.

 

In effect, valuing a startup is an exercise of calculating the best estimate of the sum of its parts, i.e., all its resources, intellectual capital, technology, brand value and financial assets that the startup brings to the table. In this article we will cover the basics of startup valuation progressing over stages of financing, need of valuing start-ups and methods of valuation, followed by a case study in the Indian market.

 

So what does a startup mean?

 

WHAT IS A STARTUP?

A startup is a business enterprise incorporated to solve a problem by delivering a new product or service under conditions of extreme uncertainty. It is a company typically in the early stages of its development.

 

These entrepreneurial ventures are typically started by one to three founders who focus on capitalising upon a perceived market demand by developing a viable product, service or platform. The founders’ effort is to turn their idea into a repeatable and scalable business.

 

In the Indian scenario, the Department for Industrial Policy and Promotion (DIPP) issued a notification in February, 2019 defining a startup as an entity which is in existence up to a period of ten years from the date of incorporation / registration with a turnover for any of the financial years since incorporation / registration not exceeding Rs. 100 crores and working towards innovation, development or improvement of products or processes or services or, if it is a scalable business model, with a high potential of employment generation or wealth creation – provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a startup.


STAGES OF FUNDING

At the initial stage, startups are self-funded by members of the founding team who also try to secure funding through an investor or obtain a loan to help fund their venture. There are various stages when a startup raises funds and its valuation differs in each stage or round of funding.

 

1.  Angel/Seed Funding – This is typically the very first stage where the funding is required for market research and developing the product. At this stage the founder personally invests or raises funds from acquaintances, or it comes from someone not known to the founder called an 'Angel Investor'. Seed capital is often given in exchange for a percentage of the equity of the business, usually 20% or less;

2.  Series A Funding – It is when startups have a strong idea about their business and product and may have even launched it commercially. Series A Funding is typically used to establish a product in the market and take the business to the next level, or to make up the shortfall of the startup not yet being profitable;

3.  Series B Funding – The startup has established itself but needs to expand, either with organic growth, with new markets or acquisitions;

4.  Debt Funding – When a startup is fully established it can raise money through a loan or debt that it will pay back, such as venture debt, or lines of credit from a bank. A venture debt fund typically lends when the startup is backed by known investor funds;

5.  Mezzanine Financing – It is also known as bridge financing because it finances the growth of companies prior to an IPO. This is usually short-term debt with the proceeds of the IPO or buyout paying it back;

6.  Leveraged Buyout (LBO) – This form of funding is made up of convertible debt or preferred shares which are more costly and provide investors certain rights over the holder of common equity. It is a strategy where someone acquires an existing company with a significant amount of borrowed funds. Usually, the assets of the business being purchased are used as leverage and collateral for the loan used to purchase it;

7.  Initial Public Offering (IPO) – An IPO is when the shares of a company are sold on a public stock exchange where anyone can invest in the business. IPO opening stock prices are usually set with the help of investment bankers.

 

A point to note is that a startup valuation is required at each stage of funding.

 

CONSIDERATIONS FOR STARTUP VALUATION


Startup valuation means believing in the story and the founders’ strength to turn it into reality. It could be the sum of all resources, technology, brand value and financial assets that the startup has developed.

 

Startups usually have little or no revenue or profit and are still in a stage of instability.

 

For startup businesses one should consider the top-down approach by looking at the total market available to the product / service and derive the cash flow to the firm / company therefrom. The following factors need to be considered and evaluated:

 

  •     Traction –This includes analysis of the active and non-active user base / subscriber base / customers of the company for the past period since inception. How fast the startup is growing vis-à-vis its competitors and where it is likely to reach in the next 12 to 24 months;
  •     Reputation of the team – The assessment of the track record of the founders includes their coming up with good ideas or running successful businesses, or development of the product, procedure or service which already has a good reputation. The risk analysis of the ventures promoted by such a team would be a bit liberal;
  •     Prototype – Whether the model or release of product built to test the concept or process is ready and tested successfully. Any prototype that a business may have that displays the product / service will help;
  •     Revenues – The visibility of revenue-generation like charging users / subscribers / customers, etc. There is also a need to check how diversified is the revenue model in different target customers or geographies or different products;
  •     Funding supply and demand – An investor is likely to pay a premium to a startup for early mover advantage. Discuss, understand and analyse the visibility of a successful business venture in a similar space, product differentiation;  the market forces, such as at what prices are similar deals being priced and the amounts of recent exits can affect the value of startups in a specific sector;
  •     Distribution channel – The valuation of a startup with a proper distribution channel in place will certainly be higher than that of one without such a channel;
  •     Industry – In case of a new idea of doing traditional business, e.g., a fintech platform, understanding and research on a particular sector is very important. If a particular industry is booming or popular (e.g. gaming), the value of the business may be more if it falls into the right industry.

 

VALUATION APPROACHES AND METHODS

Startups don’t have a long track record of generating cash flow and valuations in such cases are highly subjective. While making an investment decision, investors assess the valuation of such startups blending various methods together.

 

The following are the various valuation methodologies generally used to value startups.

 

VALUATION METHODS VIS-A-VIS PRINCIPLES

1   Berkus

Valuation based on the assessment of five key success factors

2   Risk Factor Summation

Valuation based on a base value adjusted for 12 standard risk factors

3   Scorecard

Valuation based on a weighted average value adjusted for a similar company

4   Comparable Transactions

Valuation based on a rule of three with a KPI from a similar company

5   Book Value

Valuation based on the tangible assets of the company

6   Liquidation Value

Valuation based on the scrap value of the tangible assets particularly to be used in a liquidation scenario

7   Discounted Cash Flow

Valuation based on the sum of all future cash flows generated

8   First Chicago

Valuation based on the weighted average of three valuation scenarios

9   Venture Capital

Valuation based on the ROI expected by the investor

10 Price of Recent Investment

Valuation based on the price of the recent investment round in the company

 

Berkus Method

The Berkus method, developed by Dave Berkus, is used to value pre-revenue startups and is mostly applied to technology companies. This method is based on the assumption that the company has the potential to reach $20 million or more in revenues by the 5th year of operation.

 

The Berkus method applies a scale to the following five components of a startup, rating each from zero up to $0.5 million:

(a) Sound idea (attract of core business to buyer)

(b) Quality of management (good management in place)

(c) Strategic alliance (go-to-market)

(d) Product prototype

(e) Product rollout and sales plan

 

Using this method, the highest valuation could be a maximum of up to $2.5 million and, in case of a pre-revenue startup, it could only score up to $2 million.

 

Risk Factor Summation Method

This is a slightly more evolved version of the Berkus Method. It is widely used by Angel Investors for pre-revenue startups when determining seed investing and subsequent financing rounds. The method is based on the average industry pre-money valuation and adjusted for the following 12 risk factors associated with the startup and its industry:

 

I.      Management risk

II.     Stage of the business

III.    Legislation / political risk

IV.    Manufacturing risk (or supply chain risk)

V.    Sales and marketing risk

VI.    Funding / capital raising risk

VII.   Competition risk

VIII.  Technology risk

IX.    Litigation risk

X.    International risk

XI.    Reputation risk

XII.   Exit value risk

 

Each risk factor is assessed and scored on a scale of 5 to a range of +$500K to -$500K (+$500K, +$250K, 0, -$250K and -$500K). The net out-ratings / scores are adjusted to the average industry pre-money valuation to arrive at the startup’s pre-money valuation.

 

Scorecard Method

The Scorecard Method, developed by Bill Payne, is similar to the Risk Factor Summation and Berkus Methods and is usually used to value pre-revenue startups. This method uses a combination of industry data and weighted percentages based on detailed analysis of the following quantitative and qualitative factors:

 

(1) Management team (0-30%)

(2) Size of opportunity (0-25%)

(3) Product / technology or service (0-15%)

(4) Competitive environment (0-10%)

(5) Marketing / sales channels / partnerships (0-10%)

(6) Need for additional investment (0-5%)

(7) Other factors (0-5%)

The sum of the above factors is multiplied to the industry average pre-money valuation to arrive at the startup’s pre-money valuation.

 

Comparable Transactions Method

This method is used in case of both pre-revenue and post-revenue startup valuation. It involves determining similar merger or investment transactions in the recent past and in the same industry as that of the subject company business. The relevant comparable transactions valuation is analysed based on the relevant key metrics of the industry and a range of multiples is derived which is used in the determination of the valuation of the subject company.

 

Book Value Method

The Book Value Method is an asset-based valuation approach and refers to the net worth of the company. Here, the book value is calculated by deducting the value of intangible assets and liabilities from the value of the total tangible assets. The value of total tangible assets in this case is the cost at which the asset is recorded in the balance adjusted for accumulated depreciation and impairment costs.

 

Liquidation Value Method

In this method the assessor determines the Fair Value of an asset when the company gets liquidated or if the asset is no longer usable. The method considers only tangible assets like plant and machinery, fixtures, inventory, etc., and intangibles are not considered irrespective of the value they may hold. The net liquidation value is calculated by deducting the value of liabilities from the total liquidation value of all the tangible assets.

 

Discounted Cash Flow Method

The Discounted Cash Flow method determines the attractiveness of the investment in the startup based on the present value of the cash flows and that the startup is expected to generate in future. The investor assesses the value derived from this method and the cost of the investment. In case of pre-revenue startups, the cash flows are normalised based on the stage of the life cycle of its business and once the business starts growing at a steady pace, it is believed that the business will generate cash flows for an indefinite period.

 

First Chicago Method

This method is used to value post-revenue startups. It is based on probabilities with the following three scenarios of financial forecast of the startup:

1.  Worst case

2.  Normal case

3.  Best case

 

Each valuation is made with the Discounted Cash Flow Method and assigned a percentage reflecting the probability of each scenario occurring.

 

Venture Capital Method

The Venture Capital Method, described by Prof. Bill Sahlman in 1987 at Harvard Business School, is based on the expected future returns of the investor.

 

In this method the investor assumes that after a span of ‘n’ years the startup could be sold for ‘x’ amount. Based on the expected return on investment and the sale value, the investor determines the price he / she is willing to pay today for investing in the startup, after adjusting for dilution and future rounds between now and the company sale.

 

Price of Recent Investment Method

The recent investment in the business is often taken as the base value if there are no substantial changes since the last investment.

 

The Price of a Recent Investment valuation technique is likely to be appropriate but only for a limited period after the date of the relevant transaction. Given the relatively high frequency with which funding rounds are often undertaken for seed and startup situations, or in respect of businesses engaged in technological or scientific innovation and discovery, this method will often be appropriate for valuing investments in such circumstances. Generally, Fair Value would be indicated by the post-money valuation. The length of the period for which it would remain appropriate to use this valuation technique will depend on the specific circumstances of the investment and is subject to the judgement of the valuer.

 

ASSESSMENT OF KEY PERFORMANCE INDICATORS AND METRICS

The application of the above methods is based on the assessment of risk parameters and other factors discussed earlier specific to the startup under valuation. The common set of target milestones would be established at the time of making the assessment; these will vary across types of investments, specific companies and industries, but are likely to include:

Financial Measures:

- revenue growth;

- profitability expectations;

- cash burn rate;

- covenant compliance.

 

Technical measures:

- phases of development;

- testing cycles;

- patent approvals;

- regulatory approvals.

 

Marketing and sales measures:

- customer surveys;

- testing phases;

- market introduction;

- market share.

 

In addition, the key market drivers of the company, as well as the overall economic environment, are relevant to the assessment.

 

FACTORING SCENARIOS

Therefore, using the scenario-based DCF method (DCF with First Chicago Method) that considers one or more future scenarios and assigning the probability of success to each scenario gives a reliable indication of Fair Value. Further, there is also a probability-weighted expected return model (PWERM) whereby probabilities can be assigned to the expected up rounds, flat rounds or down rounds to arrive at a value.

 

The option pricing method (OPM), a forward-looking method that considers the current equity value and then allocates that value to the various classes of equity considering a continuous distribution of outcomes rather than focusing on distinct future scenarios or a hybrid of a scenario-based method and OPM, can be considered.

 

For seed, startup or early-stage companies in the absence of significant revenues, profits or positive cash flows, other methods such as earning multiple are generally inappropriate. The most appropriate approach to assess Fair Value may be a valuation technique that is based on market data.

 

It is appropriate to use an enhanced assessment based on industry analysis, sector analysis, scenario analysis and / or milestone analysis. In such circumstances industry-specific benchmarks / milestones approach, which are customarily and routinely used in the specific industries of the company to be valued, can be used in estimating Fair Value where appropriate.

 

The DCF method may be used as cross-check; the disadvantages inherent in DCF, arising from the high levels of subjective judgement, may render the method inappropriate without corroborating support.

 

CASE STUDY

Let us discuss how one can apply the valuation approaches discussed above in a newly-started company which operates an online fund-raising platform, which connects fund-seekers with lenders. It is intended to be an end-to-end connected and fully integrated system providing a one-stop solution for individual and SME borrowers, lenders and service providers such as finance professionals and investment bankers.

 

The company has got the necessary approvals as required by the regulatory bodies in India. The company would further require approvals for using bureau data, KYC data and other government data. The company has also entered into agreements with multiple banks and NBFCs in India. However, the revenue generation is yet to be initiated.

 

Valuation Issues:

The company is in the initial stage of business life cycle. There are various competitor platforms available in the market selling a boutique of similar products and allied services.

 

Revenue generation is dependent on regulatory approvals and success fee commission from tie-ups with financial institutions.

 

The business model shared by the company projects a revenue growth at a CAGR of 200% in the first five years.

 

Valuation Approach & Methodology:

We start with understanding the business model, the market it addresses and the total size of the market, percentage share of the same the business is trying to achieve, identifying the key valuation drivers, i.e., growth rate of subscriber base and variation in success fee.

 

We then analyse the comparable transactions at various stages of funding similar to the target entity (i.e., Series A and Series B).

 

The Series A transactions were dated a year or two back to the valuation date and at a comparatively higher valuation range due to the different market scenario at the time of funding. Hence, a discount was applied to such valuation range arrived. The discounted EV / revenue multiple for Series B transactions (being the recent ones) was considered for validation check.

 

We then consider the discounted cash flow method considering three scenarios assuming lower growth rates and lower success fee ratios.

 

We need to consider a higher discount rate based on the expected returns of the investors and high risks associated with the achievement business model.

 

Valuation Conclusion:

On the basis of the above analysis, we have arrived at a valuation range using CTM and validated based on multiple scenarios and sensitivity analysis on projections and discounting rate as per DCF.

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