We frequently come across talented entrepreneurs these days and the one thing they all have in common is fear of the word “valuation”. In recent times, we have been reading a lot about valuations – valuations being slashed, over valuation, valuation models, the list goes on. It can all be a little overwhelming for someone without a financial background. So what is valuation and why is it so important for startups?
What is valuation
Valuation is the process of determining the present value of financial assets (including financial liabilities) of a company. The present value of a business might be NIL but its valuation might be lot higher. This is because the latter is based on the estimated growth potential of the business as opposed to its value today. Valuation is generally done for many reasons such as investment analysis, capital budgeting, M&A transactions, financial reporting, tax reporting, and litigation. Also, it is important for anyone to determine the value of the business if he/she wishes to invest money in a startup or raise capital for one’s own startup. Business valuation is never straightforward - for any company.
A business, which is at a very nascent stage, i.e., if its operations have recently or not yet started or funds are required for pre-launch research, assumptions cannot be based on past performance (as in the case of established and listed businesses). For startups with little or no revenue or profits, and less-than-certain futures, the job of assigning a valuation is particularly tricky.
Thus, valuation models have to be made based on assumptions and estimates of strength of the idea, experience and qualification of founder team, realistic plans, exhaustive business strategy, market research, growth potentials, and traction. At this stage, valuation is more an art than a science as there is almost no data to plug in an Excel sheet.
Valuation can be done into two ways:
Direct Valuation Method - provides a standalone valuation of company based on actual data.
Indirect valuation method –helps in arriving at a relative valuation that is comparable and can be benchmarked with the peer group. It helps ascertain whether the business is fairly priced, overpriced, or under-priced.
Direct valuation methods (absolute valuation methods)
DCF (Discounted Cash Flow) method
A discounted cash flow (DCF), as the name suggests, is the method by which the future expected cash flows are discounted to arrive at a present value. This method helps to understand whether the cash that the investment is going to generate in the future is less than, equal to, or more than the investment done today. This enables taking a wise investment decision. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity is considered good. This method is most widely used and the most relevant method in case of a startup.
The elements necessary for valuation with the DCF method are therefore
- expected cash flows
- discount rate
- growth rate
This method applies most to a startup.
Dividend discount model (Gordon model) – single period model
The Gordon growth model or DDM (Dividend Discount Model) is based on the theory that the value of the stock of any company is all future dividend payments that will be made to shareholders discounted back to the present value, assuming that dividend payments are only going to grow at a steady rate in the future.
As this method uses dividends for arriving at a valuation, it cannot be applied for the valuation of a startup. This method is most suitable for valuation of stable businesses.
Adjusted Present Value (APV) model
In this method, the calculation is made assuming the firm is 100 percent equity-funded with no leverage. Then the net effect of debt is added to the firm; the net effect is arrived at considering both the benefits and the costs of borrowing.
APV is NPV (Net Present Value) of project solely financed by equity plus the PV (Present value) of any financing benefits. It is assumed that the primary benefit of borrowing is tax benefit, and that the major cost of borrowing is the added risk of bankruptcy.
The APV method is especially effective with variating and highly leveraged capital structures.
Indirect valuation methods
The price-to-earnings (P/E) ratio is one of the most commonly used ratios of valuation for listed companies. This ratio is calculated by dividing the company’s market price per share by its earnings per share (EPS). This ratio helps calculate the market value of the stock of a company relative to its earning. The Higher the P/E, the more an investor will pay.
As this ratio is impacted by how the company is financed in terms of debt and equity and also tax payments, various variables for calculation of this ratio have been developed by analysts. They may consider EBIT (instead of EBITDA) to remove the effect of a company’s capital structure and income taxes on its earnings.
Again, due to absence of historic data, this method is irrelevant for startup valuation.
Enterprise value multiples
This is a comparable ratio, which helps arrive at a capital neutral valuation, which can be compared in the industry. This ratio gives the value of the company in terms of what it will it cost to buy a company. Also known as the EBITDA Multiple, this ratio also takes debt into account, unlike other indirect valuation methods like P/E. This ratio is best suited to make comparisons in companies within the industry.
A low ratio indicates undervaluation and vice versa.
There are various other simple methods for startup valuation
- Venture Capital Method calculates valuation based on expected rates of return at exit.
- Scorecard Valuation Methodadjusts the median pre-money valuation for seed/startup deals. This method compares the pre revenue startups to ventures in same region and business sector.
- Risk Factor Summation Method compares 12 characteristics of the target company to what might be expected in a fundable seed/startup company.
What is over valuation and under valuation
The first question that comes to mind when we hear the word “overvalued” or “undervalued” is – compared to what?
As already discussed, startups don't have a history of financial performance on which to base a valuation. Therefore, it's up to the entrepreneur to develop a process for valuing the company. To determine appropriate valuation, the company can look at two aspects:
- Comparable: How similar companies in the industry and geography are worth when they became profitable.
- Financial Forecast – Realistic assumptions have to be made regarding future revenues to back valuation and justify to investors, although this is a difficult process
Thus a correct valuation is the one that is based on well-researched numbers, assumptions, and expectations. A startup should never get too excited about over- valuing the company. The numbers committed have to be delivered causing unnecessary pressure later and also bad reputation in case valuations are slashed in revised valuations. This is what we see is happening currently in the India startup world with high-profile companies failing to live up to their private valuations, and existing and potential Unicorns coming under more scrutiny than ever before, e.g. Flipkart.
Similarly, undervaluation is also unhealthy for a company as this will lead to less funds raised and hamper growth plans when funds get exhausted mid-way.
The investors perspective
While attracting investors, it’s very important to understand their perspective. Any investor, while putting in money in the business, is looking at returns and has three major things in mind
- Exit – Every investor has this in mind. He/She will factor in how much the company will sell for, X years from now? Thus, it becomes very important to justify a good growth and expansion plan in the future.
- Funds – He/She will also estimate how much money the business will need to fund its massive growth plans to make it a X billion business. I.e. how much value it’s going to create.
- Ownership – He/She will be concerned with the ownership percentage. Early-stage investors would not want to get diluted by a VC entering at a later stage.
A well-made valuation model will answer all these questions and make the investor feel more comfortable and make a more informed decision.
The bad part with a startup is that there are no well-trodden paths to follow. But then, this is the best part too. There are no Excel sheets or number barriers at this stage of funding. Businesses can get innovative as there are no set rules.
Wisest is to not stop with one approach. Entrepreneurs may want to use several methods to value a startup, because no single method is useful every time. Multiple methods also help in the negotiation process because an average can be determined from among them.
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- Fundamental analysis
- Stock valuation
- Discounted cash flow
- startup valuation
- Business valuation
- Adjusted present value
- investors perspective
- venture capital method
- scorecard valuation method
- enterprise value multiple
- methods of valuation
- valuation of startup