Valuing Startup Businesses: Voodoo, an Exquisite Art, or a Mortal Skill
I ndia has become a hotspot for start-up investments, and a string of well-known consumer start-up IPOs have been hitting the public equity markets. NotableI POs include Zomato, Paytm, Policybazaar, and CarTrade, companies that are yet to achieve profitability. The IPOs of each of these companies were oversubscribed with strong backing from anchor investors, retail investors, and institutional investors. However, the stock price of these companies has been extremely volatile. For instance, Zomato's stock was listed at Rs.115, a significant premium to its IPO price of Rs.76. It raced up to Rs.150 before plunging to levels as low as Rs.50. This volatility has intensified the debate around the credibility of the implied valuations that VCs attributed to these companies during the pre-IPO funding rounds.
Price versus Value: Beauty Lies in the Eyes of the Beholder or Does it?
Before delving into how to value potential disruptive startups, it is important to understand the subtle difference between price and value.
Simply put, the 'price' is what the market thinks a company is worth, while ‘value' is what an investor believes a company is worth intrinsically.
By implication, the value one investor may attribute to the business can often differ widely from another. Each investor may have a different view on factors that impact the value, including but not limited to:
•The core business concept – Is the company a solution provider for a large customer base?
•The expected growth rate – A startup usually has a hockey stick shape growth trajectory.
•Ability to generate real revenues and profits – Many early startups take time to figure out 'How?' let alone 'When?'
•The capital that must be spenton marketing to acquire customers fast enough– Doesn't matter if, in the accounting world, it is called the 'cashburn'.
•The belief that market dynamics will evolve favorably to the product Requires deep knowledge of the industry.
•Confidence that the leadership team can execute their plan fast enough and continuously pivot the business model based on how customer behavior and market dynamics evolve.
•Appetite for risk, knowledge, and access to resources – This will be different for a top-tier VC firm compared to a retail investor exposed to only public equity markets, or an angel investor with real-world business experience.
Regardless of how differently each investor interconnects their views on these complex dimensions to derive an estimate of value (at a particular point in time), all of them have one common belief:
‘Eventually all other investors (the market) will also come to the same assessment as mine, and the price will converge to my estimate of value’.
What valuation methods do seasoned investors generally use for startups?
Venture capital investors, the key participants in the market, leverage multiple valuation methods and frameworks based on the range of factors discussed above. However, some of the commonly used approaches can be broadly classified.
•Income-based approaches include discounted cashflow, scenario based weighted valuation, and venture capital method. This core principle involves developing an estimate of the company's future cash flows or exit proceeds at a future date when the company has achieved the desired scale and valuation using fundamental metrics like profitability is possible. These cash flows are then discounted using an expected rate of return that commensurate the risk that the company may not successfully deliver projected financial performance.
•Market-based approaches are based on the principle of substitution involving the use of valuation benchmarks of guideline companies in public equity markets, precedent M&A transactions, or precedent venture capital deals. For example, it is common in startup ecosystems to value companies using Revenue Multiple. It is also not uncommon for early-stage startups to use valuation multiples based on non-financial metrics like active user base, the number of subscribers, or even the number of engineers when the business is yet to achieve meaningful revenues. However, while these benchmarks may be a good starting point in many cases, the adjustments to derive the value often require rigorous research and a high degree of professional judgment.
•Other hybrid methods involve scorecards using a combination of qualitative and quantitative parameters, each bearing a certain weight or value. Depending on the industry and the stage of development of the company, key parameters are identified and compared with competitors or other startups operating in the same broader industry. These parameters, which typically evaluate the mile stones that the company being valued has achieved, may include product development, strategic relationships developed, key managerial personnel hired, crowd funding success, and market validation received. The subject company is eventually valued based how it fairs in comparison to other companies while evaluating these key factors.
Doesn't sound too Difficult? Well, there is much more Beyond the Math
The risk appetite of every firm is different. Even with their experience and expertise, VCstake a call on 18- 20 companies, knowing very well that only 2 or 3 will succeed and hit a home run. Additionally, the terms on which VCs invest have a big role in implied valuation that gets mentioned in the newspapers. In almost all cases, VCs get special rights like liquidation preference, participation rights and more that offer protection to their capital in certain situations. There is a well known maxim: ‘You pick up the valuation; I will pick up the terms’. Valuing startups requires multi-disciplinary skills that intersect various dimensions industry expertise, financial chops, technology perspective, and behavioral sciences. Therefore, selecting the appropriate valuation methodology often demands a deep understanding of nature and revenue models in startup ecosystems.
Startup valuation inherently will require some degree of crystal ball gazing due to the lack of data and disproportionate research efforts it demands to tell the right story. While this cannot be avoided, simply submitting to the notion that ‘valuation is an art’ is a lazy approach, in my view. Research is important to make the right call.