Start-up Valuations

Introduction 

In Feb 2018, Ant Financial invested $200 Mn in Zomato, an online restaurant discovery and food delivery platform, with a pre-money valuation of $ 945 Mn and reached the elusive “Unicorn” tag, nearly 14 times of turnover and loss of $ 12 Mn as of March 2018. Zomato made a loss of Rs. 44 per delivery.  Ant Financial further invested $ 210 Mn in October 2018 valuing $ 1.8 Bn on a pre-money basis.

In March 2019, German food tech major Delivery Hero lead group invested about Rs 441 crore ($62.5 million) in Zomato valuing at more than Rs. 15000 crore [$ 2.2 Bn] pre-money valuation. In a one-year time, Zomato has doubled its valuation.

However, when one looks at Zomato’s financial, one realizes the company is far from profitable yet. As on financial closing, the Company achieved a turnover of $ 206 Mn and incurred a loss of $ 294 Mn [Approx Rs. 2000 Crores]. What would make Zomato so special that investors would be willing to invest in a company’s equity?

The answer is simple: growth

Zomato has grown its turnover 3x in 2019 [$68 Mn to $206 Mn]. If the company grows 1x YOY then at the end of year three its turnover reached $ 1.65 Bn and if growth will 50 % then also the company achieves a turnover of $700 Mn. Zomato is present in over 10,000 cities across the globe in 24 countries with over 1.4m active restaurants and 70 Mn active users on their platform. The company has 5m new user registrations and 11m app installations (Android + iOS), every month.

In India, Zomato serving 250 million Indians across 300 cities in India. In August 2018 Hyperpure was launched to supply fresh, clean ingredients to restaurants. Restaurants buying ingredients through Hyperpure are recognized through a ‘Hyperpure Inside’ tag on Zomato

In September 2018 Zomato acquired “Tonguestun” which aggregates caterers and restaurants for office canteens and office cafeteria.

But growth sustainability is a big “IF” for Zomato which suffers from a price discount, and higher competition from firms like Swiggy and Uber Eats.

Zomato epitomizes many of the problems that arise in the valuation of a new business: high growth potential, very limited financial history, many financial indicators such as EBITDA or Net income are negative or very small, and the risk of failure is high.

Valuation poses the most challenges at the firm since there is little useful information to go on. All those factors make it very difficult to apply the traditional valuation method to estimate the enterprise value.

Factors affecting Start-up Valuation

Generally, entrepreneurs are too optimistic in their value of businesses and when the valuation is too high then raising the funds becomes very difficult. Value unlocking is an important and iterative process. The following steps will help entrepreneurs to unlock their value in business

1. Market Size: Start-up companies work on new innovative ideas, hence the market size for the same is unknown. How the market will react to the new technology is a big challenge for the Start-Up Company. How the demand and supply of their products and services are also important for valuation.
2. Team: This is one of the most important factors for the success of the Start-Up. Investors invest in a team that is working on a start-up. An investor should be convinced that the team is capable of executing the start-up ideas practically. The team should be talented, innovative, and goal-oriented. So, start-up valuation considers management as a major factor that affects the success or failure of a start-up.
3. Traction: Business Traction implies how much business has users or revenue or customers. This provides judgment for doing the valuation of a start-up. It can vary according to from industry to industry. E.g. app installation or subscribers
4. Stage of Company: Whether the start-up is only in the ideation stage, they have made a prototype or they launched their successful operations. Investors will always prefer the start-up which has been accepted by the customers/markets so the risk of failure will be reduced to some extent.
5. Comparable: The best way to know the price of a company is to know how similar companies are priced. Comparable company is also one of the factors affecting valuation.

Limitation of Traditional Valuation Method

Below are traditional approaches which are used for valuation and how these are having limitation while valuing the start-ups:

Discounted Cash Flow [DCF] Method

Discounted Cash Flow, The most common and more logical method for valuations. The limitation for using this method is as follows:

1. Business Forecast: To value the Startups, business plans or revenue forecasts should be accurate or near to accuracy. DCF method depends on the Business Plans. This is easy for a stable company as a business plan can be derived from history. We generally do not have such a history for a start-up.
2. Terminal Value: Most of the value is embedded in Terminal Value. Terminal Value is calculated after explicit horizon period over [stage where the company reaches maturity]. Terminal Value for start-ups represents generally 90 or 100% of the firm’s value. No one can have an idea of the time when a start-up reaches maturity.
3. Discount Rate: It is the rate of return that investors expect from investing in the company [typically WACC]. Generally, it is computed by using the comparable listed company’s un-levered Beta. But for finding comparable will be difficult for the start-up,
4. Asset generation: DCF method evaluates cash flows from existing assets but also expected growth from both new investment and enhanced efficiency on existing In the case of start-ups, their existing assets are small and it is hard to estimate the real performance of those assets because of the lack of financial data. Therefore, most of the value will come from “growth assets”, namely the assets that the firm will put into place with future investments but we do not indicate their profitability.

Comparable Multiple Method:

The best way to know the price of a company is to know how similar companies are priced. This method uses various multiples like P/E, EBITDA, EBIT, or Industry-specific revenue multiple of similar industry/company for valuing factor. There are three major limitations under this method which are as follows:

1. Comparable Company: Start-up Company will not have the same as a listed company or comparable company. While scouting for the comparable company following characteristics should be kept in mind i.e. same growth rate, same risk, same margins, same tax rate, same investment, and financial structure. It is unlikely that a comparable company with the same characteristic will be available
2. Negative bottom-line: In a start-up, multiple like P/E, EBITDA, EBIT is meaningless as the profit will be very less or negative hence valuation using multiples will be meaningless.
3. Similar Funding: Comparing with the start-up company who has done the funding in recent period will also not give correct valuation as terms and condition of funding into that company is unknown. [e.g. shareholders agreement]

Net Assets Method

Asset light method is now a day becoming very popular. In this method, start-up companies rather than purchasing the fixed assets, entering into leasing, renting, licensing agreements with the owners of the assets for using the assets. So, this is becoming the limiting factor for valuing start-up using the Net Asset Method. Start-up companies do not own significant assets. Valuation with the net asset method will not be useful. In 2014, Facebook agrees to pay $ 19.6 Bn for Whatsapp, which has only 55 employees and no assets

Start-up Valuation Method

Venture Capital Method

Venture Capital Method was published by Mr. Professor William Sahlman in the year 1987. This is the most popular method used by venture capitalists to determine post-money valuation. Before, understanding Venture Capital Method, we must first understand the following terms which are been used in the Venture Capital Method:

1. Harvest Year: The year in which the investor wants to exit. For Example, if the harvest year is the 5^th year, this means that the investor wants to invest in the start-up company for 5 years. After the 5^th-year investor wants to exit.
2. Pre Money Valuation: The Valuation of the company before the investment is made.
3. Post Money Valuation: Post Money Valuation of the company is a total of Investment Made and Pre Money Valuation. This can be written in equation form:

Post Money Valuation = Investment Made + Pre Money Valuation

Process of Valuation under Venture Capital Method under two steps:

1. First, derive the terminal value of the business in the harvest year.
2. Second, work backward using the desired ROI and investment amount to derive the pre-money valuation.

Example:

A venture capitalist is looking for an investment of INR 100 Lakhs in a start-up technology for 5 years. The company is expected to earn INR 200 Lakhs profits in the 5th year. Comparable companies in the peer group have a PE Multiple of 12 times & the VC is negotiating a return of 20% on its investment

The valuation will be at the 5th year = Profit * PE Multiple 200*12=2400 lakhs

The required future value of investment (20%) = Investment X (1+required return) ^5

= 100 * (1.20) ^5

= 250 lakhs (Rounded off)

So, VC’s stake 250/2400=10.41%

Berkus Method of Valuation

Berkus’s method of valuation is a method for valuing Start-up Companies. Berkus Method was designed by Mr. Dave Berkus in the mid-1990s and it is being used since then. This method is mostly used for technology start-ups, but it can be used for other start-ups also. According, to Mr. Dave Berkus, 1 in 1000 start-ups earns the revenue as projected by management. So, he doesn’t rely on the financial projections

For valuation, he then designed his valuation method which is known as Berkus Method. According to Berkus Valuation, there are five major elements for the success of the Start-up Namely Sound Idea, Prototype, Quality Management team, Strategic Relationship, Product Rollover, or Sales.  In this method, value is assigned to each element according to its progress. According to Berkus Method, $500,000 is the maximum value that can be earned from each element, explained below:

 Hence, the maximum value of a start-up company is $2.5 Mn. The investor can put the less amount for each element according to the risk and progress. This method is the simplest and convenient. Also, an investor can add critical elements for valuation as per the nature of Start-up Companies.

Scorecard Valuation Method

The scorecard Valuation Method is also known as the Bill Payne Valuation method. It was developed by Mr. Bill Payne in the year 2011. This method is an improved version of the Berkus Method. It has a more market approach. It compares the other start-ups which got funding at a very similar stage with Target Money.

First Step: Calculate average pre-money valuation of other start-ups which got the funding having similar business as of target company.

Second Step: Evaluate the target company in 7 Critical factors (Weights for each factor are given in the table below), rate them between 0.50 to 1.50, and arrive at a weighted average rating.

Third Step: Multiply the total average weighted rating factor as arrived in step two with the average pre-money valuation of other start-ups company as calculated in the first step.

Risk Factor Summation Method

Risk Factor Summation Method (RFS Method) takes into account the average pre-money valuation of comparable start-ups (as calculated in the Scorecard Method). This is the first step. The Second Step is to evaluate 12 factors (as mentioned below) and assign them a rating in the range from -2 to +2 according to the risk associated with each factor.  It is to be noted that 1 Rating is equal to $250,000. The third Step (Final Step) is to add the value of each factor into the pre-money valuation of other comparable start-ups to arrive at a valuation of a start-up.

Below are 12 factors in RFS Method:

1. Management
2. Stage of Business
3. Legislation/Political Risk
4. Manufacturing Risk
5. Sales and Marketing Risk
6. Funding/Capital raising Risk
7. Competition Risk
8. Technology Risk
9. Litigation Risk
10. International Risk
11. Reputation Risk
12. Potential Lucrative Exit

First Chicago Method

First Chicago Method is used by venture capitalists and private equity investors. This method was developed first by Chicago Corporation Venture Capital. First Chicago Method uses the three scenarios while valuing the Start-up. The first is the Best Case Scenario, the second is Base Case Scenario and the third is the Worst Case Scenario.  It values the business in all three cases by using either Venture Capital Method or Discounted Cash Flow Method. Next step after valuation in all three cases, you have to assign a probability of happening of each scenario.  Then you multiply these probabilities by respective values and add them up. This gives you a weighted average of combined scenarios.

Closing the Valuation Gap

The three most important reasons for the Valuation Gap are as follows:

1. The first reason for the valuation gap is, they are too much optimistic about their business, which ends up in a high valuation of the business. Hence, this causes a difference in valuation.
2. The second reason for the valuation gap is choosing a different valuation method by entrepreneurs and investors.
3. The third most reason for the valuation gap is the entrepreneur’s expectation vs. investor’s expectation.

To close the valuation gap, the Entrepreneur should take professional advice from a Registered Valuer.

Shares with Differential Voting Rights

A company limited by shares is permitted to have equity shares with differential voting rights as part of its share capital. It benefits the company for obtaining investments without offering voting rights to the investor. Issuance of shares with differential voting rights allows such private companies to broaden their capital base without having to lose control over or management of the company.

Staged Closings

In Staged Closing, funding is done in tranches. For each tranche, some milestone or target is set. If that is completed, then only the next tranche will be released.  If the pre-agreed milestone is not achieved, the investor can release the funds. In that case, an investor will receive additional shares in the company against the initial pre-money valuation, thereby increasing the overall stake in the company.

Warrants

An investor who funds a company against Entrepreneur’s higher valuation. By structuring the call option at the same price, the Investor can protect his downside. He purchases the additional shares at a pre-agreed price if the company underperforms or does not meet pre-agreed milestones.

Deferred Valuation

In this method, start-up investors can defer the negotiation of valuation to the next round. In simple words, Investor fix the same valuation for certain period say 6 to 12 month for the next round or ask for warrant coverage to acquire shares if the company require funding in this period

Valuation Collars

Caps and Collars is a minimum and a maximum valuation that protects investors and entrepreneurs if the subsequent valuation is outside that collared range.

Here’s an example that illustrates both perspectives. Say that investors and entrepreneurs cannot agree on a valuation. Investors want Rs. 100 Crore pre-money and entrepreneurs Rs. 150 Cr. To move forward, both agree on a 25% discount at the next round—without a collar. If the next round were done at Rs. 400 Crore pre-money, the 30 percent discount (Rs. 280 crore pre-money) would still be 2.67x higher valuation than the entrepreneurs would have taken for the current round. Even though such rocket-ship starts are highly unusual, investors should not give up that potential by not including a collar.

To protect the entrepreneur’s interests, the agreement might be a 25 % discount to the next round with a collar of Rs. 100 Crore to 150 crore or Rs. 80 Crore to 170 Crore.

Liquidation Preference Shares

An investor can ask for the preference shares of the company or convertible preference shares for closing the valuation gap. As preference shares are preferred over ordinary shares during the liquidation of the company.