Valuation of Startups

The traditional approaches to valuation are inadequate for the valuation of newage startups. The business model has undergone a fundamental change, especially in the 21st century. Profitability is no longer a key value driver for new age startups. Listed startups like Paytm (which is not even a startup anymore) openly submit that profitability is not their goal in the foreseeable future. In such a day and age, it is imperative that the parameters for valuing such startups be attuned to their business model. In this article, the author attempts to shed light on finding a startup’s true value.

By its very nature, valuation is highly subjective. For instance, let us consider the world-famous painting of the Mona Lisa. The painting is worth billions for some, whereas others may consider it an average work. Therein lies the beauty of valuation in the eyes of the be holder.

The three most common globally accepted methods of valuing a business are tabulated below for ease of understanding: Income ,Asset & Cost Approaches.
These methods have been used in the valuation of businesses for decades and have been accepted by businessmen, lawmakers, Courts and investors alike.
However, one common feature in the above approaches is that it pre-supposes a business that is established and generates cash flows using its assets.
Startups, by their very definition, are disruptors. They disrupt industries, products and processes using innovative means. It is difficult to call them “established” in any sense or assume that their cash flows (if not already spent on marketing) will remain constant. Profitability seems to be a cursed word in the startup investor circles.
As we will explore later in this article, the traditional methods find themselves inadequate to arrive at the value of a new age startup.
With the dawn of the 21st century, new methods have emerged that attempt to find the startup’s true value. But a good valuer understands that the actual value lies less in the numbers and more in the story of the startup.
In this article, we look at the basics of valuing any business and how to go about valuing a new age startup.
The valuation of startups is often required for bringing in investments either by equity or debt. The most significant differentiating factor in the valuation of a startup is that there is no historical data available based on which future projections can be drawn.
The value rests entirely on its future growth potential, which, in many cases, is based on an untested idea and may not have been based on an adequate sampling of consumer behaviour or anticipated consumer behaviour. The estimates of future growth are also often based upon assessments of the competence, drive, and self-belief of, at times, very highly qualified and intelligent managers and their capacity to convert a promising idea into commercial success.
The major roadblock with startup valuation is the absence of past performance indicators. There is no ‘past’ track record, only a future whose narrative is controlled based on the founders’ skill. It can be equated as founders walking in the dark and making the investors believe that they are wearing night vision goggles. While this is exciting and fun for the founders, this is risky for the investors.
This is why valuation of startups becomes critical and the role of a professional comes in – it is a way of definitively helping investors navigates the dark using facts, rather than fairy tales.

Why traditional methods cannot be applied?

Each of the commonly used methods discussed above pre-suppose an established business – which is profitable, has established competitors and generates cash using its assets.
However, this is missing in new age startups whose value can lie majorly in the concept and potential rather than numbers with a track record.

The failure of each of the traditional methods in case of new age startups is tabulated below:

Income approach

A vast majority of startups operate under the assumption of not generating positive cash flows in the foreseeable future. Off late, this business model has been accepted and normalised by the investor community as well. Since there are no or minimal positive cash flows, it isn’t easy to value the business correctly.

Asset approach

There are two reasons why this approach does not work for new age startups:

Startups have negligible assets – a large chunk of their assets are in the form of intellectual property and other intangible assets. Valuing them correctly is a challenge and arriving at a consensus with investors is even more difficult.
Startups are new, but usually operate under the going concern assumption. Hence their value should not be limited to the reliable value of assets today.

Market approach

New-age startups are disruptors. They generally function in a market without established competitors. Their competition is from other startups working in the same genre. The lack of established competitors indicates that their numbers may be skewed and not be comparable enough to form a base. However, out of the three traditional approaches, we have seen a few elements of the market approach being used for valuing new-age startups, especially during advanced funding rounds.

As we have discussed above, the traditional methods fall short of recognising the true value of new age startups. The inherent question is what methods we should use for valuing new-age startups. To understand that we have to see what factors drive their value (no prizes for guessing – profitability is not one of them).

Value Drivers for startups

While every startup can be vastly different, we now take a look at a few key value drivers and their impact on the valuation of a startup. Drivers Impact on valuation

Product

The uniqueness and readiness of the product or service offered by significantly impact the company’s valuation. A company that is ready with a fully functional product (or prototype) or service offering will attract higher value than one whose offering is still an “idea”. Further, market testing and customer response are key subdrivers to gauge how good the product.

Management

More than half of Indian unicorn1 startups have founders from IIT or IIM. While it may seem unfair primary, it is a fact that if the founders are educated from elite schools and colleges, the startup is looked upon more favourably by the investors and stakeholders alike. Accordingly, it is imperative to consider the credentials and balance of the management. For instance, a team with engineers is not as well balanced as a team comprising engineers, finance professionals and MBA graduates. Keeping aside the apparent subjectivity in evaluating the management, the profile of the owners plays a crucial role in valuing the startup.

Traction

Traction is quantifiable evidence that the product or service works and there is a demand for it. The better the traction, the more valuable the startup will be.

Revenue

The more revenue streams, the more valuable the company. While revenues are not mandatory, their existence is a better indicator than merely demonstrating traction and makes the startup more valuable.

Industry attractiveness

The industry’s attractiveness plays a vital role in the value of a company. As good as the idea may be, to sustainably scale, various factors like logistics, distribution channels and customer base significantly impacts the startup value. For example, a new-age startup in the tourism industry will be less valuable, as innovative or unique as their offering is if significant lockdowns are expected in the future.

Demand – supply

If the industry is attractive, there will be more demand from investors, making the industry’s individual company more valuable.

Competitiveness

The lesser the competitors, the more valuable the startup will be. There is no escaping the first-mover advantage in any industry. While it is easier to convince investors about a business that already exists (for example, it must have been easier for Ola to convince investors when Uber was already running successfully), it also casts an additional burden on the startup to differentiate itself from the competition.

Methods for valuing startups

One key observation would be that most value drivers described above are highly subjective. Hence, there is a need to provide standard methods using value drivers 1 “Unicorn” is a term used in the venture capital industry to describe a privately held startup company with a value of over $1 billion. The term was first popularized by venture capitalist Aileen Lee, founder of Cowboy Ventures, a seed-stage venture capital fund based in Palo Alto, California. above in order to value the startup in a manner comparable to others.

There are many innovative methods for valuing startups that try to reduce the subjectivity in the valuation of startups that have come in recent times. Let us take a look at the most common methods of valuing startups:

Method Particulars

Berkus Approach The Berkus Approach, created by American venture capitalist and angel investor Dave Berkus, looks at valuing a startup enterprise based on a detailed assessment of five key success factors:

Basic value
Technology
Execution
Strategic relationships in its core market
Production and consequent sales

A detailed assessment is carried out evaluating how much value the five critical success factors in quantitative measure add up to the total value of the enterprise. Based on these numbers, the startup is valued. This method caps pre-revenue valuations at $2 million and post revenue valuations at $2.5 million. Although it doesn’t consider other market factor, the limited scope is useful for businesses looking for an uncomplicated tool.

Cost-to-Duplicate Approach

The Cost-to-Duplicate Approach involves taking into account all costs and expenses associated with the startup and its product development, including the purchase of its physical assets. All such expenses are considered determine the startup’s fair market value based on all the expenses. This approach is often criticised for not focusing on the future revenue projections or the assets of the startup.

Comparable Transactions Method

With the traditional market approach, this approach is lucrative for investors because it is built on precedent. The question being answered is, “How much were similar startups valued at?”. For instance, imagine XYZ Ltd., a logistics startup, was acquired for Rs 560 crores. It had 24 crore, active users. That’s roughly Rs 23 per user. Suppose you are valuing ABC Ltd, another logistics startup with 1.75 crore users. ABC Ltd. has a valuation of about Rs 40 crores under this method. With any comparison model, one needs to factor in ratios or multipliers for anything that is a differentiating factor. Examples would be proprietary technologies, intangibles, industry penetration, locational advantages, etc. Depending on the same, the multiplier may be adjusted.

Scorecard Valuation Method

The Scorecard Method is another option for pre-revenue businesses. It also works by comparing the startup to others already funded but with added criteria. First, we find the average pre-money valuation of comparable companies. Then, we consider how the business stacks up according to the following qualities.

Strength of the team: 0-30%
Size of the opportunity: 0-25%
Product or service: 0-15%
Competitive environment: 0-10%
Marketing, sales channels, and partnerships: 0-10%
Need for additional investment: 0-5%
Others: 0-5% Then we assign each quality a comparison percentage

Essentially, it can be on par (100%), below average (100%) for each quality compared to competitors/ industry. For example, the marketing team has a 150% score because it is thoroughly trained and has tested a customer base that has positively responded. You’d multiply 10% by 150% to get a factor of .15. This exercise is undertaken for each startup quality and the sum of all factors is computed. Finally, that sum is multiplied by the average valuation in the business sector to get a pre-revenue valuation.

First Chicago Method

This method combines a Discounted Cash Flow approach and a market approach to give a fair estimate of startup value.
It works out

Worst-case scenario
Normal case scenario
Best-case scenario

Valuation is done for each of these situations and multiplied with a probability factor to arrive at a weighted average value.

Venture Capital Method

As the name suggests, venture capital firms have made this famous. Such investors seek a return equal to some multiple of their initial investment or will strive to achieve a specific internal rate of return based on the level of risk they perceive in the venture. The method incorporates this understanding and uses the relevant time frame in discounting a future value attributable to the firm. The post-money value is calculated by discounting the rate representing an investor’s expected or required rate of return. The investor seeks a return based on some multiple of their initial investment. For example, the investor may seek a return of 10x, 20x, 30x, etc., their original investment at the time of exit.

Rising above numbers – The Story An article about the valuation of startups cannot be complete without understanding the importance of storytelling in the valuation journey. Professor Aswath Damodaran, expert of valuation, puts forth. “If all you have are numbers on a spreadsheet, you don’t have valuation You just have a collection of numbers”. Let us attempt to understand the importance of stories in valuation by way of an example of valuing the shares of Rolex. We will try to appreciate company in three scenarios and the reader may assume the role of an investor on the verge of making an investment decision.

Scenario 1

The earnings of company are slated to grow at 9.5% for the next 8 years before dropping down to the GDP growth rate; the Operating Profit Margin will be 43%, the Net Profit Margin will be 16% and it will be able to generate Rs 2.54 for every rupee invested in the business.

Scenario 2

Rolex is a manufacturer of luxury watches that can charge astronomically high prices for its watches, earn huge profit margins due to scarcity of luxury watches available to an exclusive club of wealthy individuals.

Scenario 3

Due to the need to maintain its exclusivity, the revenues of the company will grow at a low rate of 9.5% for the next 5 years. The same need for exclusivity also allows the company to earn an above average operating margin and maintain stable earnings over time because the client base of the company is relatively unaffected by the highs and lows of the economy.

As the reader would notice, Scenario 1 deals exclusively with the numbers whereas scenario 2 deals with the story. Scenario 1 will not inspire an investor but scenario 2 will not help the investor reach a conclusion either. It is only in scenario 3 where the value of the business is derived by tying the numbers to the story of the company. Here, the numbers get a backing and are easier to understand for the potential investor. Merging storytelling with the numbers is the real hallmark of a good valuation.

Prof. Aswath Damodaran has laid down a brief five-step process for integrating story into numbers. The same is explained below:

A cocktail Nobody knows what the future holds, and valuers are not astrologers, though their success is largely measured by how well they can predict the future.

Step 1

Develop a narrative for the business being valued In the narrative, you tell a story about how you see the business evolving over time.

Step 2

Test the narrative to see if it is possible, plausible and probable There are lots of possible narratives, not all of them are plausible and only a few of them are probable.

Step 3

Convert the narrative into drivers of value Take the narrative apart and look at how you will translate it into valuation inputs, starting with potential market size, moving onto cash flows, risk. By the time you are done, each part of the narrative should be reflected in the numbers and each number should be backed up with a story.

Step 4

Connect the drivers of value to a valuation Create an intrinsic valuation model that connects the inputs to an end-value in business.

Step 5

Keep feedback loop open Listen to people who know the business better than you do and use their suggestions to fine tune the narrative / alter it.

It is said that valuation by itself is a combination of science and art. The author has a unique take – valuation is a scientific art. It is an art constructed by the valuer, yet there is a definite method in the madness. The sanctity of a valuation is preserved by being able to back up the numbers using rational numbers, narratives and assumptions.

New-age startups are disruptors in their own right and a necessary tool for global innovation and progress. By their very nature, startups disrupt set processes and industries to add value. In that process, they transcend traditional indicators of success like revenues, profitability, asset size, etc. Accordingly, it is no mean feat to uncover the actual value of a startup. While the traditional methods fall short, there is no shortage of new innovative methods used to value startups based on their value drivers. However, the valuation of a startup is much more than the application of ways – it is about understanding the story of the future trajectory and communicating that narrative using substantial numbers.