Startups and their valuation

What comes to your mind when you think about the word 'start-up'- Flipkart, Ola cabs, Oyo rooms or some other successful start-ups. Nobody remembers the failures but as per the recent study conducted by Forbes nearly 90% start-ups fail in India. So what do you think might be the reason of their failure?- Poor idea or weak management or founders losing interest, might be, but only 20%  failures are result of these factors. The most important reason for their failure lies in the definition of start-ups itself. As per Eric Ries, a revolutionary author and founder of various start-ups across the Silicon Valley, a start-up means:

'A human institution designed to create a new product/service or existing product/service with new use under the condition of extreme uncertainty.'

Yeah, uncertainty is the reason behind failure of most of the start-ups across the globe because if you can't predict, you can't set goals and if you won't set goals you can't achieve the desired results.

The greatest victim of start-ups uncertainty is their value estimation. Almost, every 2nd startup is either over valued or undervalued. Valuation of start-up is considered as art rather than a perfect science. Traditional methods of valuation like DCF (Discounted cash flow method) or market capitalization method can't be used to estimate the value of your start up, since you have no idea about the future because of uncertainty.

Start-ups initially are dependent upon private equity rather than public markets, initially by family or friends and as companies promise to success increases VC's comes into picture. Valuation of start-ups at early stage is more about its growth potential as opposed to its present value which is almost zero in the beginning. The factors influencing the value of start-ups are:

Traction: It means no. of users you have in your customer base. Investors prefer start-ups that can prove that they can be successful. The faster you get users, the more they are worth.

Management Reputation: Entrepreneurs with prior exists, tends to have higher valuation. But some people received funding without traction and without significant prior success. Two such examples are founder of Instagram and founder of Pinterest.

So, to make this art of start-up valuation a science, there are certain methods used by Venture capitalists, few of them as under:

1. Venture Capital Method:

One of the most common approach used to value young firms, is by mixing intrinsic value and Relative valuation approach called Venture capital approach. This approach has four steps to it:

Step 1: Since the uncertainty about the future estimate become greater as we go further out in time, so we began by estimating expected earnings or revenue on future date, though not too far typically two to five years from now. Generally, the period is set to match the time Venture capitalist plans to sell the investment.

Step 2: Value of the firm at the end of forecast period is calculated by multiplying  forecasted earnings calculated in step-1  with P/E(Price/earning)multiple of some other firm in the similar industry that have been sold to VC's or gone public recently.

Value of firm (at the end of forecast period)- P/E Multiple * Estimated earning of forecast period.

Step 3: Now, the value of venture as on today is calculated by discounting value determined in step 2 with the target return of venture capitalists, generally set high enough to capture both the perceived risk in business and the likelihood that the firm will not survive. Since likelihood of firm not surviving is high in case of start-up's, target rate is set quite high( around 50%-70%) as compared to discount rates we use with other publically traded companies.

Value of firm today = Value at the end of forecast period (n) (calculated in step 2)
                                                                          (1+ target VC's return) n

Step 4: The venture capitalists receive proportion of value they invest in start-up. To make judgement of what proportion of firm they are entitled to, capital introduced by them is added to value derived in step-3(Pre money valuation) to arrive at post money valuation.

Proportion of VC's share = New capital introduced/Post money valuation.

Another method which is highly used in recent days is scorecard method or benchmark method, derived by bill Payne.

2. Scorecard Method: This approach has 3 steps to it:

Step 1: Gather Pre-money valuation of other companies in your sector and then calculate average of such valuations.

Step 2: Now, compare your venture with other similar ventures on following aspects:

 Say, if your company performance for one of the above aspect is about average to other companies, write down 100% as your score. If it is stronger than average write number greater than 100%,say 150% if you analyse that your venture is 50% better than average in a particular aspect.

Hypothetical sheet will look alike:

Step 3: Multiply sum of those factors, as shown in table above by pre-market value determined by you in step 1.The result is Pre-market value of your venture.

3. Berkus Method:

Another method, which is optimum for technologies start-ups, is Berkus method, devised by David Berkus. This method not often used these days due to limitation of value of start-up derived using this method. According to this method maximum possible valuation of a company can be $2.5 million i.e. approx. 18 crores. As per this technique if certain characteristics exist, then add $0.5 million to your valuation.

Note that these numbers are maximums that can be 'earned' to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but certainly also allowing the investor to put much lower values into each test, resulting in valuations well below $2.5 million.

Conclusion: Start-ups and uncertainty goes hand in hand in the start-up world, it's the uncertainty and the risk involved that makes this start-up world unique and people engaging. As far as valuation of your start-up is concerned, rather than using one single method of valuation you can use multiple methods and compare the results to get the better picture, though much depends upon your negotiation and liasoning skills, how you will the battle of your value and share to be offered for the same with Venture capitalists.