Valuation of Start-Ups – A deep dive
Outside/third-party funding is a low-cost mechanism for Start-ups to raise funds for their businesses. In view of the same and exponential rise and growth of Start-up ecosystem in India has led to increased funding requirements from Start-ups, whether on private placement basis or through capital markets. Accordingly, the mechanism for valuation of Start-ups has gained prominence over the past few years. Indian regulators are also taking keen interest in this exercise and creating conducive policy environment by appointing nodal authorities and/or making relevant policy changes under various Indian laws to regularize this field. In this article, I have discussed few aspects that are relevant and should be kept in mind while valuing a Start-up. I have also discussed few common approaches and methods that are generally used for valuation of Start-ups in India and around the world.
‘Start-ups’ has been a buzz word for some time now. This has been possible due to the much-needed impetus provided by the policy makers especially by Government of India. In 2016, the Government of India announced its flagship initiative for building start-ups (‘Start-Up Scheme’) and nurturing innovation with the main objective to boost entrepreneurship, economic growth and employment across India. Under the Start-Up Scheme, several benefits were granted to start-ups from legal perspective, funding support, fast tracking of patent applications at lower costs, benefits under Income-tax Act, 1961 etc. This policy initiative had a favourable impact on the entire Start-Up ecosystem and as a result number of start-ups were set-up in India.
As on December 24, 2022, more than 86,350 start-ups have been recognised under Start-Up Scheme and around 993 Start-Ups have been granted income tax related exemptions. Further, as per data available on Start-Up India website more than 3,260 start-ups have been funded by SIDBI Funds of funds1. India currently houses the 3rd largest start-up ecosystem in the world after US and China. As per media reports, as at July, 2022 India had 105 start-ups with valuation of over $1 billion or having the coveted ‘Unicorn status’2.
In past few months, entities from start-up community like Zomato, Paytm, Policybazaar, Nykaa etc. have raised capital from Indian stock markets. Many others like Ola, OYO, Flipkart etc. are said to be in process of getting their equity shares listed on Indian Stock Exchanges. These facts prove India’s potential in becoming the Start-Up capital of the world and also lays emphasis on their valuation.
What is a Start-Up
Under the Start-Up Scheme, a Start-Up has been defined as an entity incorporated or registered in India which:
- a) Is a private limited company or registered partnership firm or a limited liability partnership;
- b) Has not yet completed a period of ten years from the date of incorporation/registration;
- c) Has an annual turnover not exceeding Rs. 100 crores for any of the financial years since incorporation/registration;
- d) Is 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; and
- e) It is not formed by splitting up or reconstructing a business already in existence.
Valuation aspects to be kept in mind for valuing Start-Ups
1) Subjectivity and Non-Exact Nature
Valuations of start-ups or new-age businesses are integral to the business ecosystem, aiding strategic decision-making and governance. However, business valuation is not an exact science; although it uses data, facts, and reports, it is prone to subjectivity based on user interpretation, underlying assumptions, and valuation purpose.
2) Early-Stage Complexity & Market Volatility
Start-ups often raise funding early when cash flows and future visibility are not streamlined and depend heavily on regulations, competition, and market shifts. A notable example is the sharp post-listing fall in equity prices of start-ups in capital markets vis-à-vis their issue price due to shifting investor expectations.
3) Pre-Revenue Valuation Considerations
In cases where only a working prototype exists without commercialization, valuation relies significantly on qualitative factors: promoter pedigree, strength of the business model, and business execution plans.
4) Maximizing Observable vs Minimizing Unobservable Inputs
To curtail subjectivity, valuers must maximize observable inputs (publicly available market transaction data, active market quoted prices) and minimize unobservable inputs (internal entity-level cash flow forecasts).
5) Pricing Sensitivity and Dilution Impact
Because start-ups prefer raising equity capital with minimal operating history, valuation precision is vital:
- Valued Below Fair Value: Causes excessive, unnecessary equity dilution of promoter stake.
- Valued Above Fair Value: Deters potential investors, leading to fundraise failure.
Approaches and methods for valuation of Start-ups
1. Market Approach
The most preferred approach for early-stage start-ups when recent transactions in similar business models exist. Minimizes unobservable inputs and reflects market expectations. Computed via two primary methods:
- a) Comparable Public Company Method: Identifies a comparable listed peer and makes necessary adjustments for size, liquidity, and operational divergence.
- b) Precedent Transactions Method: Benchmarks recent public acquisition/funding transactions in similar entities, applying appropriate valuation adjustments.
“Market Approach is the most preferred vis-à-vis other approaches especially in case of early-stage start-ups especially in a scenario where transactions have happened in recent past in entities with similar business models and size.”
2. Income Approach (Discounted Cash Flow)
Applied when the start-up can project future free cash flows with reasonable certainty, discounted by a risk-adjusted rate reflecting the premium over risk-free investments.
Regulatory Scrutiny Warning: Tax authorities in India actively compare valuation DCF projections against actual post-investment performance during Income-tax audits (e.g., Angel Tax assessments under Section 56(2)(viib)), sparking widespread litigation currently pending across various appellate forums.
3. Cost Approach (Asset-Based Approach)
Estimates the reproduction/replacement cost of business assets adjusted for obsolescence. Rarely suitable for start-ups, as their primary value lies in intellectual property, growth potential, and network effects rather than physical asset accumulation. Primarily used in capital-heavy entities or liquidations.
Other Specific Methods for Start-Ups
a) Exit Multiple / Venture Capital Method
Designed for VC investors aiming for a medium-term liquidity exit rather than permanent holding. Follows 3 steps:
- Step 1: Compute expected terminal exit selling price of the venture investment at exit horizon.
- Step 2: Determine target ROI hurdle rate (e.g., 2x, 3x, 5x, 10x).
- Step 3: Discount terminal value by target ROI to arrive at post-money valuation, deducting investment capital to derive pre-money valuation.
b) Score Card Method
Compares a pre-revenue target start-up against funded peers across weighted strategic criteria (team, market size, competition, funding need, marketing approach):
Table b: Score Card Valuation Framework
| Criteria | Score (A)# | Weight (B)# | Factor (A * B) |
|---|---|---|---|
| Strength of the team | 120% | 0.30 | 0.360 |
| Size of market | 80% | 0.15 | 0.120 |
| Competitive environment | 100% | 0.25 | 0.250 |
| Need for additional investment | 100% | 0.15 | 0.150 |
| Strength of marketing approach | 150% | 0.15 | 0.225 |
| Total Factor (X) | 1.105 | ||
| Value of comparable Start-up (Y) | 1,00,000 | ||
| Value of Start-up under discussion (X * Y) | 1,10,500 | ||
Note # - Weight can be decided by the valuer basis the facts of the case and its comparable(s). Further, Score needs to be determined considering the relative performance of the Start-up with its comparable on a given set of criteria.
c) Berkus Method (Dave Berkus Model)
Named after American angel investor Dave Berkus, valuing early pre-revenue start-ups by assigning discrete monetary values across five building blocks:
Table c: Berkus Method Valuation Framework
| Criteria | Range* | Value assigned |
|---|---|---|
| Sound idea | 0 to 3,50,000 | 3,00,000 |
| Technology | 0 to 3,50,000 | 2,50,000 |
| Management team | 0 to 3,50,000 | 2,75,000 |
| Strategic relationships | 0 to 3,50,000 | 2,25,000 |
| Production and subsequent sales | 0 to 3,50,000 | 2,50,000 |
| Final value of Start-up under discussion | 13,00,000 | |
Note * - Range can be decided by the valuer basis the facts of the case, its comparable(s) and after considering the maximum value that he is willing to allocate to a particular criterion.
d) Risk Factor Summation Method
Takes an initial computed base value and applies quantitative monetary additions or deductions based on risk profile across management, reputation, competition, capital, technology, legal, and political exposures.
“The Risk Factor Summation Approach values a startup by taking into quantitative consideration all risks associated with the business that can affect the return on investment.”
Table d: Risk Factor Summation Valuation Framework
| Criteria | Level of risk | Value assigned* |
|---|---|---|
| Initial computed value | - | 10,00,000 |
| Risk related to the management | Low | +50,000 |
| Reputation risk | Normal | - |
| Competition risk | High | -75,000 |
| Funding/ capital risk | Normal | - |
| Technology related risk | High | -75,000 |
| Legal risk | High | -50,000 |
| Political risk | Low | +75,000 |
| Final value of Start-up under discussion | 9,25,000 | |
Note * - Value is assigned to each risk basis the facts of the case and its comparable(s).
Conclusion
As can be seen from above, there are a number of methods that can be used for valuation of Start-ups. There is no right or wrong method and any of the above methods can be used considering the facts and circumstances of the case including but not limited to nature of business, stage of start-up (i.e. whether pre-revenue, revenue commencement stage, post revenue), availability of listed peers, recent market transactions in similar space etc. The approach and method to be selected for valuation of Start-up should be such that use of observable inputs should be maximized to arrive at the valuation.