Valuation of Startups while raising funds (Companies Act, 2013)

Startup is the buzzing word now! Indians are now willing to try, willing to experiment and take pride in having their own startup. Every successful venture was once a Startup. The Social media also has contributed for the success of Startups.

When a Startup plans to raise funds, there are certain compliances to be taken care of under the provision of The Companies Act, 2013 and the recent addition being requirement of Valuation Report, be it any kind of funding – Seed round, Pre Series funding, Bridge Round, Series funding (1,2,3,A,B,C….),  Angel funding, Private Equity etc.

Valuation Report when required :

Under the Companies Act, while raising funds a Startup has to obtain Valuation Report by a Registered Valuer (RV) before issuing following instruments under Private Placement or on Preferential basis [Sec 62(1)(c)], –

• Equity Shares
• Partly or Optionally or Compulsory Convertible Preference Shares
• Partly Optionally or Compulsory Convertible Debentures

Valuation report is also required when Shares or Securities to be allotted for consideration other than cash [Rule 13(2)(g) of The Companies (Share Capital and Debentures) Rules, 2014], issue of Sweat Equity Shares etc.

In case of Optionally Convertible Securities, the price of the shares shall be determined either upfront at the time when the offer is made on the basis of Valuation report of the Registered Valuer given at the stage of such offer or at the time, which shall not be earlier than thirty days to the date when the holder of convertible security becomes entitled to apply for shares, on the basis of valuation report of the registered valuer given not earlier than sixty days of the date when the holder of convertible security becomes entitled to apply for shares [Rule 13(h) of Companies (Share capital and Debentures) Rules, 2014] The Company must obtain Valuation Report and consider the issue price or conversion price of Securities before the Board Meeting date wherein the funding proposal will be recommended for shareholders approval at General Meeting.

Valuation Report when not required :

Valuation is not required if the securities are issued on rights basis or in case of Compulsorily Redeemable securities.

Who can issue Valuation Report:

As per Rule 11 of The Companies (Registered Valuers and Valuation) Rules, 2017 only a Registered Valuer registered with IBBI (Insolvency and Bankruptcy Board of India) may render valuation services under The Companies Act w.e.f. 1st February 2019. The Registered Valuers are also required to obtain a valid Certificate of Practice as per the guidelines, if any,  specified by their respective Registered Valuers Organisation before issuing any Valuation Report. We have less than 500 Registered Valuers in India under Securities or Financial Assets Category as of date.

How to appoint Registered Valuer:

As per the provisions of Sec 247 (1) of the Companies Act, 2013 Registered Valuers must be appointed by the Board of Directors of that company [Audit committee, if any]

What information is to be shared with the Registered Valuer :

The following information is required to be shared by a startup with the Registered Valuer preferably under a Non Disclosure Agreement to obtain the Valuation Report –

1. Brief profile of the Company and Promoters

2. Audited financials of the previous three years (if applicable)

3. Projections for 3 or 5 years as required – Balance Sheet, Profit and Loss and Cash Flow Statement

4. Shareholding Pattern along with details of category of Shares held

5. Details of Borrowings

6. Details of Convertible Securities

7. Basis for or Assumptions underlying projections

8. Existing Customer Contracts, if any

9. Shareholder Agreements, if any

10. All important Agreements having a bearing on the valuation of the Company

11. Material information affecting Valuation

12. Litigations, if any

Valuation Standards to be followed by Registered Valuers(RVs):

The Registered valuer shall make valuations as per following standards which have to be mentioned in the Valuation Report –

(a) internationally accepted valuation standards;

(b) valuation standards adopted by any registered valuers organisation.

Valuation Methods to be followed by RVs for a Startup Valuation :

There are several commonly used and accepted methods for determining the fair value of the business of a company. They mainly fall under the following three categories:

A. Income based valuation approach (“Income Approach”).

B. Net Asset Value based valuation approach (“Asset Approach”); and

C. Market based valuation approach (“Market Approach”);

The application of any aforesaid methods of valuation depends on the nature of operations, level of maturity of the businesses, future business potential and purpose of valuation. For the purpose of arriving at the fair value of the Equity shares of the Company, it would be necessary to select an appropriate basis for valuation from among the various alternatives available.

The Asset Based Valuation Method is not an appropriate method of valuing a startup business, because it does not truly measure the earning capacity of an enterprise and its growth potential.

The Market Based Valuation Method is also not an appropriate method since startups are not a listed company, they do not have a market price readily available for Valuing the Company. The Startups cannot be compared with listed comparables as well.

The Discounted Cash Flow (DCF) method under income approach is commonly used. It is accepted as an appropriate method by business appraisers. This approach constitutes estimation of the business value by calculating the present value of all the future cash flows which the company is expected to generate. Mathematically it can be expressed as the following formula: PV = ΣFV / (1 + i)^n

Where, PV = Present Value, FV = Future Value, i = discount rate reflecting the risks of the estimated future value, n = raised to the nth power, where n is the number of compounding periods.

Discounted Cash Flow Method values the equity on the basis of its future cash flows and it has two components as follows: (i) Discounted value of Free Cash Flows of the company for the Explicit Forecast Period and (ii) Terminal Value (value after the explicit forecast period).

Mandatory contents of Valuation Report:

As per Rule 8 of The Companies (Registered Valuers and Valuation Rules), 2017 the following shall be stated in the Valuation Report-

(a) background information of the asset being valued;

(b) purpose of valuation and appointing authority;

(c) identity of the valuer and any other experts involved in the valuation;

(d) disclosure of valuer interest or conflict, if any;

(e) date of appointment, valuation date and date of report;

(f) inspections and/or investigations undertaken;

(g) nature and sources of the information used or relied upon;

(h) procedures adopted in carrying out the valuation and valuation standards followed;

(i) restrictions on use of the report, if any;

(j) major factors that were taken into account during the valuation;

(k) conclusion; and

(l) caveats, limitations and disclaimers to the extent they explain or elucidate the limitations faced by valuer, which shall not be for the purpose of limiting his responsibility for the valuation report.

Few important terms defined :

Relevant Date for valuation: The price of the securities should be arrived at as of a date which is at least 30 days prior to the scheduled date of the general meeting approving the issuance.

Valuation Date : The date on which the Registered Valuer values the company.

Valuation Report Date : The date of issue of report by Registered Valuer.

Date of Appointment : The date on which the Board of Directors appoint the Registered Valuer.

Author – Shilpa Kiran G, Registered Valuer, Insolvency Professional, Company Secretary in Practise, from Bangalore and can be contacted at [email protected]