‘Start Ups’ has become a buzz word. As we speak- a revolution is on. A very healthy ecosystem is evolving with the government as well stepping in, to being a facilitator. The proposed tax holiday, waiver of capital gains tax and a significant startup fund of funds as mooted by the government will go a long way in easing the conditions for the entrepreneurs. The enabling environment notwithstanding, there are certain unique features of a startup which a student of finance should be aware of.
The uncertainty of capital employed and return on capital employed (ROCE)
A lot of startups begin with an idea. But every brilliant idea need not be a scalable one and every scalable idea need not be a feasible one. Google came into being from the idea of having a more powerful and efficient search engine, with the founders having no or perhaps little clue of how it would succeed from a ‘viability’ perspective. Google AdWords came in much later. The amount of investment that an evolving startup would require and the ROCE it would generate are quite hard to predict. This makes the entire investment proposition very uncertain and which lends very little to traditional risk analysis and measurement.
The founder is not a ‘rational’ investor
The person(s) who spearhead the startups are not rational investors. They take high risks, putting almost everything at stake- their lifelong savings, job security etc. While we teach and are taught the virtues of diversification, the ‘dreamers’ believe in that ‘one‘ idea, probabilistically having little chance of success. Most of the disruptive startup ideas would have never come into play, had the founders speculated upon the risk adjusted returns.
Equity- the preferred means of financing
Given the uncertainty of topline coupled with high fixed costs to begin with, the operating leverage is fairly high in most startups. It is a long gestation period of negative cash flows, with financial breakeven far out of sight. Talk of Flipkart, Olacabs, Snapdeal – most of these startups are far from being profitable. To scale up, theseventures need money. Negative operating cash flows in early stages make debt financing the inappropriate route. It enhances the risk further (recall, DTL=DOL*DFL).
Match the beta of asset with that of liability. And therefore equity is the appropriate choice of liability that the young company should take. Founders in a bid to prevent the dilution of their stake, resort to debt financing. This very often spells hara-kiri for the founder and his startup. Remember it is better to own 50% of success than own 100% of failure.
Valuation- lies in the eyes of the beholder (also known as investor)
As students of finance, we feel very comfortable with the discounted cash flow (DCF) approach of valuation. Simply put, valuation of a business is a function of the cash flows it is expected to generate. And greater the stability of cash flow, greater the valuation (on account of lower discount rate). Not only is it a challenge to get a sense of future cash flows that would be generated by the startups, it is perhaps as much a challenge to extend an appropriate risk adjusted discount rate.
The uncertainties related to most startup models make the valuation exercise of such businesses all the more subjective, easily lending itself to the biases of the investors. What justifies the high valuation being attributed to the likes of Flipkart (over $15 billion), Snapdeal (over $6.5billion), Ola ($5 billion), Zomato ($1 billion)?DCF approach in these cases could potentially be a self-fulfilling exercise by taking inputs (discount rate and growth rates) that could lead to desired valuation.
One must concede that value of such startups emanate from future cash flows and its growth. The current earnings (or the lack of it) cannot be used to judge the valuation of startups. Traditional multiples like PE, EV/EBITDA would be ‘blunt’ tools (as Damodaran very aptly puts it) to value the Twitters of the world! Increasingly a hybrid of DCF and multiple methods are being used to value such companies.
Alternatively, convenience lies in latching upon to some tangible metric (like Gross Merchandise Value or GMV in case of Flipkart and the likes) and using it to extrapolate valuation or the valuation gap between two comparable startups.
Keep learning!
Amit Parakh
A Finance Enthusiast. SFM/ CFA/ FRM Trainer
To avail SFM classes, click here.
Source: Corporate Finance -Brealy & Myers, Corporate Finance- Vernimmen, Corporate Finance-Damodaran, Economic Times
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