By Chander Sawhney, Partner & Head-Valuations & Deals, Corporate Professionals
Headquartered in Delhi, Corporate Professionals is a one-stop-shop of widest spectrum of corporate services. This leading corporate advisor helps customers with Corporate Restructuring, Corporate Compliance and Due Diligence, Investment Banking, Securities Laws advisory and many more.
The Internet based businesses globally have seen unprecedented growth and now with India taking a center stage in global markets because of high growth & reform expectations, demographic dividend and large market, many Indian startups have come out, especially in the last couple of years, building scalable businesses (substantially Tech-enabled) to solve a multitude of problems we face in our daily life.
The key characteristics of start-up companies is that they don’t have any past history, the operations has not reached the stage of commercial production, have negligible revenue with high operational losses and limited promoter’s capital infused with high dependence on external sources of funds. The investments are also Illiquid in nature. Startup Funding has Dried Up with Investors looking when and if ventures would turn profitable.
Till 2015, Start Up valuations was closely linked to the valuation of U.S. and China tech start-ups and investors felt the fear of missing out. Investors were relying on a different metric of valuations, ‘GMV’ gross merchandise value which is defined to indicate total sales value for merchandise sold through a marketplace over a period. The more you scale, the more was the valuation and focus was not on creating a profitable biz model.
Interestingly the trend of Investments has remained difficult and different in 2016. Many e-tailers have reported decline in number of orders significantly as they cut discounts leading to drop in their GMV raising eyebrows on their fresh funding rounds and valuations. Instead many startups have reported Down Rounds (funding at lower levels) and so many of them have even shut their shops. Many startups have also changed their business model looking at unit economics and profitability.
The impact of above is that Angel Funding and Serial A Funding is at all-time low and now the focus is back on the basics – business model validation and positive Cash Flows.
For valuing mature companies there are broadly three approaches to valuation namely Asset Approach, Income Approach & Market Approach. However, these approaches do not find much of relevance for valuing the Start-ups as they often have insignificant revenue or EBITDA metrics, insufficient history, no meaningful comparable(at their stage) and long term income/ cash flow projections are quite difficult to estimate.
There are three ways to value startups namely Venture Capitalist method, First Chicago Method, Adjusted discounted cash flow method.
Venture Capitalist Method
Venture Capitalist Method is majorly used by venture capitalist looking for making investments in start-up companies. Let’s take an example: Suppose Venture Capitalist (VC) is willing to make investment of $ 1.0 million in a startup technology company for a period of 5 years. The company is presumed to be earning $2 Million. Net Profits in year 5 and the company comparable are fetching a price earning (PE) multiple of 10x and the VC requires a 20 percent return on its investment. The critical question is how much equity stake the VC should need to get for its investment.
Required Future value of Investment = (Investment) X (1+ IRR)^5
= ($1.0 Mn ) X (1+20%)^5
Now, at that point the company must be valued at
= 5th Year Net Profits * PE Multiple
= $2Mn X 10 = $20 Mn
Hence, VC shall be getting = $2.49/ $20 = 12.44 percent
First Chicago Method
The value of Start-Up in this method is determined using Comparable Companies Multiples (based on Existing or Exit year financial metrics)
First Chicago approach then takes into consideration three business scenarios: Success, Failure and Survival case and associate probability to each case based on the stage of business and qualitative metrics to arrive at the weighted average value.
To conclude, Start-up valuation depends a lot on judgment and qualitative factors like Founders and Co-Founders background, experience and passion, Biz Model, Scalability potential of business (with or without technology), Competitive landscape, Current Traction. Startup’s often operating in the valley of death which requires considering the probability of their success and failure. In a way, Start-up valuation also involves validation of business model which makes it complicated vis-à-vis other valuations. As everything is future driven in start-up, the experience of valuer plays a significant role in value conclusion.