“The great growling engine of change- Technology”– Alvin Toffler
With the world becoming tech savvy a lot of ideas have popped up into the human mind giving birth to a new word in the business sector ‘Start-up’. Start-up is basically a new company on the very beginning stage of its operations and are often initially financed by the entrepreneurs behind the idea.
There are three stages of a start-up:
1. Pre-Seed: Pre- Seed stage is the very initial stage of starting a start-up business. It is the first instance of fundraising, which is generally done from within the family investors or friend investors or the angel investors. In this stage the business is in its conceptual phase and thus it does not require a huge amount of funding from the very beginning thus internal investment on these types of projects can be made. Apart from this, the pre-seed phase fills in the gap between the very beginning of the business and subsequent seed funding rounds.
2. Seed: Seed Stage is the second phase in the Start-Up business. This is where the main execution of the plan begins from. The funding received in the seed stage is invested into product development and market research. There are many potential investors in a seed funding situation: founders, friends, family, incubators, venture capital companies and more. After the development phase of the product is completed the User base can be identified.
3. Series: The series stage is split into 3 stages:
In the light of the above company requires the source of funds throughout these stages and to attract the external investors the company must get itself valued. Valuation is the process wherein the worth of the company and future benefits from the company are required to be computed so that the potential investors can compute the benefits. Investors pours in the funds in Start-Up in exchange for the part of equity in company. Valuation is important as it helps in determining the equity which they must give to the investors in exchange of funds. In case the company is valued at lower rate, but the company earns higher returns in the future thus the company ends up providing greater portion of the equity than it should have been provided. And in other case if the company is valued at the higher rate but the company earns lower returns then investors will be at the loss. Thus, it can be said that the valuation can be game changer in the start-up business. However, there are certain constraints at the time of valuing a Start-Up because of the unavailability of the information regarding the factors responsible for valuation. The factors that are responsible at the time of valuation are hereunder:
1. Traction: It is a factor that determines the likeness of the product in the market based on the response amongst the present and the prospective customers. The factor determines whether the company will hold for long in future and develop.
2. Reputation: Investors are always interested in those companies whose founders have good reputation in the market. It becomes especially important for the founder to maintain their reputation in a market.
3. Prototype: No one believes an idea unless there is some visual model of that. Before aiming for the investors, the founders must always create a prototype for more chances of being invested.
4. Pre-valuation revenues: Investors only invest if they foresee future benefits. The revenue earned by the company just after the product hits the market also plays a key role in attracting investors.
5. Industry: Another factor is the type of industry the start-up has decided to jump into. If the new start-up is planned for in the type of Industry which is growing rapidly in that case it is most likely that investors will get attracted to such start-up.
However, despite being aware of the above factors the process of start-up valuation can be tiring and sometimes even the computation goes wrong. That is why it can be said that start-up valuation is not a guesswork. In fact, it is quite different from the Mature Business.
Mature Business valuation is much easier because of the availability of the financial records of the previous years. However, in case of newly formed company the valuation is dependent upon the estimates made upon the factors mentioned above which is a very tough challenge to compute. Further young firm does not have significant investments in land, building or other fixed assets and seem to derive the bulk of its value from intangible assets. The negative earnings and presence of intangible assets are used by analyst a rationale for abandoning traditional valuation models and developing new ways that can be used to justify investing in young firms.
However there still exists different methods which can be used under start-up valuation:
1. Book-value Method
This method is solely dependent on the values of the tangible assets. The start-up is valued on the value of the tangible asset possessed by it. However, it is to be pointed out that this method is really of no use in case of start-up valuation. Start-ups are usually focused upon building intangible assets, like creating an idea and research and development. In the very initial stage of start-up sometimes, the company does not even possess tangible assets. In such situation the method becomes non-applicable.
2. Cost-to-Duplicate Method
This method involves calculating how much it will cost to build another company just like the present one. The reason behind this method is that it is rationale to think that no investor will invest more than what will be required to start a new similar company. However, the method is incomplete in valuing the business as it ignores the factors like returns on investments, sales of the business and the future profits to be earned. Mainly the investors fund such businesses because they want to earn something in return if the valuation will be completely based on the cost to be incurred and not based on the future benefits to be offered in that case the method becomes incomplete.
3. Discounted Cash Flow Method
This method focuses on projecting the start-ups future cash flow movements. ‘Discounted rate’ is to be estimated depending upon the numerous factors. A higher discount rate is applied to start-ups to cover higher rate of risk.
4. First Chicago Method
This method is a bit lengthy process of valuing a start-up. It involves creating three different scenarios a) Worst Case Scenario b) Normal Case Scenario c) Best Case Scenario. This method uses discounted cash flow method for valuation in each of the abovementioned scenario. Then the percentage of probability of each of the scenario is assessed. The valuation in this method is the weighted average of each case. This method is useful for post-revenue Start-ups.
5. Venture Capital Method
This method is used for showing the pre-money valuation of pre-revenue start-ups. It uses the following formulas:
a) Return on Investment (ROI) = Terminal Value ÷ Post-money Valuation
b) Post-money Valuation = Terminal Value ÷ Anticipated ROI
As the name suggests the method is from the perspective of the Investors. Since the major reason why an investor invests in the business is for the returns thus the method focuses on the valuation of the future returns. This method is meant for pre-revenue and post-revenue start-ups.
6. Berkus Method
Berkus method is a brainchild `of a Venture Capitalist and Angel Investor David Berkus. The idea behind the method is to assign values to the maximum limit of half a million each to 5 key factors namely:
a) Concept- The product should offer basic value with acceptable risk.
b) Prototype- Having a prototype reduces the level of uncertainty and technological error to a certain point. Thus, more value can be assigned if the prototype created is more reliable.
c) Quality Management- The Start-ups should also have the hold over the quality of the Product they are dealing with. The start-up should hire Quality Management team for the same.
d) Connections- To remove the competition risks in the market it is better to build connections.
e) Launch Plan- A plan to launch the product in the market as well with the mission to roll out same in the markets for the sale.
Each of the aspect is assigned with the value of half a million. By assigning the values the valuer gets the estimate in relation to the value of the Start-up. This method is made for valuing the company in its pre-revenue stage.
7. Future valuation Multiple Approach
The method focuses solely on the estimation of the return on investment that can be expected by the company in near future, say five or ten years. Several projections are to be conducted during the estimation like growth projections, cost, and expenditure projections etc. Since the valuation is based on the future projections and estimates particular care is to be taken while considering the factors and market trends used while doing the estimation.
8. Market Multiple Approach
This is the most used method of valuation and it works like the most multiples do. In this method the base multiple is determined based on value of recent acquisition. The start-up is valued using base market multiple.
9. Risk Factor Summation Method
This method requires a great level of analysis further it also requires finding out the various risk factors that can affect the company. The method is a combination of Score card method and Berkus method. In this method score and value as mentioned hereunder is assigned to different risk factor.
The said values are to be adjusted based on the level of risk and are added or subtracted as the case maybe on the initial value of the company (to be computed by using other methods). There could be several kinds of risks including Management Risk, Funding/Capital Risk, Manufacturing Risk, Sales and Marketing Risk, Technology Risk, Political Risk, Litigation Risk, International Risk etc.
10. Scorecard Valuation Method
This method also works by evaluating the other similar types of business by including further additional criteria. The first step in the method is to compute the initial value of the start-up. The next step is to assign the weightage percentage based on stacks given hereunder:
a) Strength of the team: 0-30%
b) Size of the opportunity: 0-25%
c) Product or service: 0-15%
d) Competitive environment: 0-10%
e) Marketing, sales channels, and partnerships: 0-10%
f) Need for additional investment: 0-5%
g) Other: 0-5%
The next step is to assign the comparison percentage to each of the above quality. You can assign the percentage as being on par (100%), below average (<100%), or above average (>100%) for each quality compared to your competitors. For example- Team functionality is given percentage of 150% and the weightage assigned is 30%. Both are multiplied to get the factor of 0.45. In the comparable manner all the above criteria are to be computed and the total sum of the factors so computed will be multiplied with the Initial value computed in the first step.
However irrespective of the method of valuation a valuer picks up, it is important to have reality checks in between. Since in case of start-up valuation, there is no evident information available to evaluate and form a conclusion it becomes a tiring job for the valuer to estimate the correct value. In fact, since the business environment is dynamic it becomes important for the valuer to keep the track on the changes in the internal & external business environment. Despite of the methods available for the valuation, the process of determining various factors and analysing them is an art and not science.
About the Author: The Author, Deepanshu Gupta, is a Registered Valuer in asset class securities or Financial Assets and is a practicing Chartered Accountant, Managing Partner of DGA which is a multi-disciplinary audit and advisory firm providing gamut of services including audit, income tax, valuations, consulting and outsourcing services and can be contacted at firstname.lastname@example.org