VALUATION OF STARTUPS

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:

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

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.