Valuation of Startups: What we’re doing and what we should be doing
The valuation of startup companies should ideally be no different than the valuation of any other company. However, their lack of history, lack of comparable, uncertain future makes their valuation a complicated exercise. In many cases, startups are “priced” rather than “valued” by the investors. Valuers should consider important factors while using the DCF method of valuation. More importantly, valuers should increasingly use Cost Approach for valuing pre-revenue startups and consider Scorecards to assess various parameters suitable for the valuation of startups.
Startups have emerged as powerful engines of wealth creation, innovation, and mass impact in today’s dynamic business landscape. Driven by a spirit of creativity and risk-taking, startups have the potential to disrupt industries and reshape economies.
India’s startup environment is vibrant and dynamic, characterized by rapid growth and innovation. As one of the world’s fastest-growing startup ecosystems, India has witnessed significant growth in the number of startups. They have created huge impact across various sectors, including technology, e-commerce, fintech, health tech, edtech, agritech, and renewable energy.
However, valuing startups poses unique challenges due to their rapid growth, evolving nature, and high-risk environment.
“As one of the world’s fastest-growing startup ecosystems, India has witnessed significant growth in the number of startups.”
Defining Startups
While there is an ongoing effort among G20 members to establish a common definition of a startup, we will continue to refer to startups that are young, innovative, and growth-oriented companies.
In India, an entity is required to fulfil the following criteria to be recognised as a Startup and avail tax benefits under DPIIT:
- The Startup should be incorporated as a private limited company or registered as a partnership firm or a limited liability partnership.
- Turnover should be less than INR 100 Crores in any of the previous financial years.
- An entity shall be considered as a startup up to 10 years from the date of its incorporation.
- The Startup should be working towards innovation/improvement of existing products, services and processes and should have the potential to generate employment/create wealth. An entity formed by splitting up or reconstruction of an existing business shall not be considered a “Startup”.
Evaluating Startups for Valuation
Just like any other business, evaluating startups require a good understanding of business model. Since there is limited history, the key challenges for the valuers is that they must make assumptions about the future of the business based on the management narrative and their own judgement.
Life Cycle Stage (from Pre-Revenue companies to Free Cash Flow generating companies)
A companies’ age and maturity is an important factor in business valuation. A company which is in ideation stage and does not have a ready product may not be assigned great value. There is nothing on the ground and the idea may never take off. Plus, there is no copyright or patents available on an idea. So, valuers should avoid placing premiums on companies based on PowerPoint presentations and Founders’ selling skills.
The valuations may go up as the company scales in terms of developing a product, hitting the markets (generating revenues), confirming the Product-Market-Fit (PMF), generating operating profits, pivoting to navigate through competition, scaling through operating milestones, and generating positive free cash flows.
Competition
Startups often face barriers to entry, such as regulatory hurdles and high capital requirements. Overcoming these barriers is crucial for long-term success. Additionally, startups must establish sustainable differentiation by offering unique value propositions, disruptive technologies, or innovative business models to stand out in crowded markets.
A startup may have innovated a process or product, but valuers must be careful before assigning it a premium. In this age of rapidly evolving technology, it’s easier for competition to catch up quickly. Operating in a crowded market increases the risk of market erosion, as intense competition can lead to price wars, reduced profit margins, and challenges in acquiring and retaining customers. Valuers must understand the Total Addressable Market (TAM), including its size, growth rate, and market trends, for estimating a startup’s growth potential and overall valuation.
Valuers should be cautious when founders claim about how their business is unique and will beat competition. They must exercise their own judgement and experience.
Figure 1: Decision Pathway – Future of the Company in Valuation
Business Model
Apart from competition, the scalability, and ability to consistently meet market demand are vital factors in assessing a startup’s potential for growth. A recurring revenue model, shorter sales cycle, and compelling value proposition contribute to a startup’s valuation. Demonstrating consistent growth, customer engagement, and retention are strong indicators of a startup’s potential value. Valuers should also assess if the business is solving a real problem or is a discretionary spend. While there is market for both and both can drive value, they have unique consequences in future viability.
Case Study: Flipkart – Pioneering Cash on Delivery (COD)
During its journey to become the giant that Flipkart is today, it pioneered the concept of Cash on Delivery (COD). It overcame the hurdle of low credit card usage in India and accelerated the adoption of online shopping. The company’s customer-centric approach ensured that discounts were focused on benefiting customers, while its constant experimentation and innovation allowed it to stay ahead of market trends. Flipkart’s efficient logistics strategies, adaptable commission policies, and recognition of high-performing sellers further solidified its position as a transformative force in the Indian e-commerce market.
Founders and Team
Evaluating the team’s experience, expertise, potential, technological capabilities, and co-founder dynamics is crucial for assessing a startup’s long-term viability. However, just because the founder was a CEO of a large tech company doesn’t mean he can be a good entrepreneur. Having a strong board of advisors may be helpful but will not drive strong premiums. Advisors usually don’t have their skin in the game and often are the first ones to jump ship when businesses go south.
For a Tech-based company, a non-tech founder may have built a tech product through outsourcing. The tech vendors may replicate the product for others or may not provide services beyond a point. In the absence of a tech team and a tech founder, the technology risk increases. Valuers should consider such factors in valuation.
Financials
The ability to generate incremental revenues, and positive contribution are key considerations while valuing startups. Evaluating the startup’s potential to sustain cash flows and high margins is also crucial. Specific factors such as burn rate, use of funds, previous funding rounds, past valuations, and dilution also play a significant role in determining a startup’s worth.
“The ability to generate incremental revenues, and positive contribution are key considerations while valuing startups.”
1. Employee Stock Ownership Plans (ESOPs) and Convertibles
Startups frequently use ESOPs and convertible instruments for fundraising and incentivizing employees. These complex financial instruments require careful consideration in valuation to account for their potential impact on the company’s value. While assessing the value of convertibles (e.g. Warrants, Optionally Convertible Preference Shares, Compulsorily Convertible Preference Shares, Optionally Convertible Debentures or Compulsorily convertible Debentures), valuers must assess the terms of conversion carefully, apply option pricing techniques (where applicable) and assess the value. Also, while arriving at the value per share, valuers must assess the impact of dilution of such convertibles.
The startup may command a high valuation premium or a discount based on the evaluation of startups as shown below.
Figure 2: Evaluation Framework for Pre-Revenue and Early Stage Start-ups
- Cost Approach
- Income Approach (High Probability of default)
- Using Benchmark multiples (where available)
- Lower Discount Rate (with lower probability of default)
Methods of Valuation
1. Market Approach
Market approach relies on market values of the subject asset or of comparable companies. Finding comparable companies for benchmarking purposes can be challenging for startups. Startups operate in unique niches, and even if comparable companies exist, they may not be suitable for direct comparison.
Comparables (Comps)
This method involves looking at the valuations of similar startups in the same industry and region. It’s important to consider factors like the stage of development, growth potential, and market conditions. For companies where a recent valuation has been done, valuers can use those as a reference point and check for updates or differences. While early stage startups use Price to Sales multiples to arrive at comps based valuation, there isn’t enough reliable data and such multiples can be very divergent. Valuers must exercise caution while applying multiples.
Precedent Transactions
Similar to comps, this method looks at the valuations of startups that have recently been acquired or gone public. This can provide insights into what investors are willing to pay for similar businesses.
2. Income Approach: Discounted Cash Flow (DCF)
DCF involves estimating the future cash flows the startup is expected to generate and then discounting them to their present value. This method requires making assumptions about revenue growth, profitability, and the discount rate.
Some of the things to note around financials include:
1. Historical and projected financial statements:
Startups usually have limited financial history, making it hard to identify meaningful trends or apply traditional revenue/profit multiples. Valuers should ensure that the projected financial statements (wherever provided by the management) are reasonable.
For example, revenue forecasts, should be backed with robust assumptions along with probabilities and scenarios. The profit margins should be reasonable and in line with industry benchmarks. Valuers should understand that revenue growth may not come without capital expenditure and marketing spends, which requires funds availability.
In case of profitable ventures, where profits are ploughed back, the working capital assumptions and profit margins should be reasonable. Further, the cash flows should factor in the uncertainties around the business.
Startups often go through frequent pivots, changing their business models, target markets, or product offerings. This high level of uncertainty makes reliable projections challenging, as the future direction of the startup may not be clearly defined. Valuers should ensure that the financial projections incorporate such scenarios or possibilities.
2. Financial statement adjustments:
Valuers may have to make suitable adjustment to financial projections:
a. Research & Development:
Valuers should see if the company has invested heavily in technology or in Research & Development. While accounting regulations require expensing most R&D costs, for valuation purposes, some of these can be treated as Intangibles. Suitable adjustments must be made to assess what portion of these expenses are expected to yield benefits in the long run. Valuers should suitably model the intangibles leading to capitalisation of some of the expenses and amortising them over a reasonable period. Consequently, the profitability and cash flows would take a different shape than the reported financial statements.
Similar adjustments may have to be made for discretionary spends, promoter or key managerial personnel (KMP) salaries and other items that should be recorded as per industry benchmarks. For example, if the company is utilising the founders’ services, the cash flow projections should consider suitable expenses attributed to the founders even if they are not taking salaries. In case these expenses are not adjusted in the cash flows, valuers should make suitable adjustments in the discount rates to consider such factors.
Discount Rates & Default Risk
While Capital Asset Pricing Model (CAPM) serves as a good reference point for assessing the cost of equity, the absence of Beta becomes a hindrance in applying CAPM. While many authors and practitioners argue in favour of using the comparable listed companies, the risk profile is usually very different for startups as compared to listed peers. Valuers may consider an additional risk premium with suitable assumptions to incorporate risk factors applicable to startups. This additional risk premium may incorporate, among other things, lack of marketability, size discount, unreasonable projections (where management provided cash flows are not fully defensible), business risk in pivoting to other models and more. Such Adjusted CAPM approach or the Build-up Method may allow valuers to consider the overall riskiness of the cash flows while applying discount rates.
While some regulations prefer Discounted Cash flow Method of valuation for valuing startups as well, predicting financials of a young startup is extremely risky and a simple DCF may not be the right method to value startups. Even if applied, sensitivity analysis or even Monte Carlo Simulations must be considered before arriving at a final value.
In its simplest form, valuers must assess a probability of default especially in case of early stage or pre-revenue startups. Accordingly, the valuation may be assessed as follows:
3. Risk-Adjusted Return (Venture Capital) Method
The Venture Capital method provides a framework for investors to assess the potential value and returns of startups. By considering future earnings, market multiples, and the time value of money, this method helps guide investment decisions and negotiations between startups and venture capitalists. This approach considers the risk associated with investing in startups. Investors often use a higher discount rate to account for the higher level of risk involved. This method involves several steps to determine the expected value of a company:
- Step 1: The expected future profits (PAT) or any other value driver such as Revenue or EBITDA in a specific year are estimated. These value drivers are then multiplied by their respective multiples, such as the Price-to-Earnings (PE) ratio to arrive at the Terminal Value or the Exit Value.
- Step 2: The estimated value is then discounted back at the target rate of return to arrive at the present value of the company as per the Venture Capitalist.
- Step 3: The next step involves calculation of Post Money Value and VC Stake. By calculating the post-money value and the venture capital stake, investors can determine their expected returns and the percentage of ownership they will hold in the company.
Example: EdTech Company Om Ltd
A young EdTech company Om Ltd is expected to go public in 10 years. The projected net profits of the company at that time are estimated to be INR 95 crores. The average PE multiple of publicly traded EdTech companies is 20. Investors are seeking a 45 percent return on their investment until the company goes public.
Using the Venture Capital method, we can calculate the exit value by multiplying the projected net profits (95) by the average PE multiple (20), resulting in an exit value of INR 1900 crores. To determine the present value of the company, we discount this exit value over 10 years at the target rate of return (45%). The value of the company today is then estimated to be INR 46.25 crores.
It is surprising that where valuation has been arrived at between investors and company based on such approach, the Valuers still end up assessing the valuation based on Discounted Cash Flow Method for compliance purposes where the projections are unreasonable. Indeed the regulations must be amended to allow VC method of valuation for startups.
4. First Chicago Method
The First Chicago Method combines multiples-based valuation and discounted cash flow (DCF) valuation. It involves four key steps: defining future scenarios (Best, Base, Worst), estimating divestment prices using multiples for each scenario, determining the required rate of return and calculating the value under each scenario, and assigning probability weights to each scenario to derive the weighted sum. This approach provides a comprehensive way to assess the value of an investment opportunity by considering different scenarios, incorporating market-driven risks, and accounting for their probabilities.
5. Asset-Based Approach (Cost Approach)
This method involves valuing the startup based on its tangible and intangible assets, such as patents, technology, equipment, and intellectual property. Cost approach would normally not assign a high premium to startups. Valuers should apply cost approach in cases where the startup has not demonstrated a Product Market Fit (PMF) and does not generate meaningful revenues.
6. Berkus Method or Scorecard Method
This method assesses startups based on five key criteria:
- The soundness of the idea
- The quality of the management team
- A prototype or product in development
- Strategic relationships
- The potential for a viable exit strategy
Each of these criteria is assigned a value, and the total value is used to estimate the startup’s worth. Berkus method itself is seldom applicable to startups in the Indian context. It has a tendency to overvalue entities, which should be taken into consideration when using this approach.
However, scoring the startup on various factors may provide a rich input and may be a valuable tool for the valuers to arrive at a defensible valuation when applied with other methods of valuation (e.g., comps or Discounted Cash Flow method). Valuers should also consider segregating the startups into various stages (e.g., idea stage, prototype stage, revenue-generating stage). The valuation may increase as the startup progresses through these stages.
Conclusion
In a nutshell, it becomes challenging to value startups due to their rapid growth, evolving nature, and high-risk environment. They differ from mature companies in terms of agility and limited resources. Valuation methods like Venture Capital, First Chicago, Berkus, and DCF provide frameworks for estimating startup value. Factors such as competition, TAM, scalability, team expertise, and financial indicators are crucial. Challenges include limited financial history, unique accounting treatments, complex instruments, and uncertainty. Understanding these methods and challenges enables informed decisions to harness the innovation and growth potential of startups.