Valuation of Start-up Companies

Preamble

This Article is written with a view to understanding the Valuation of Start ups where it differs from that of an ongoing company i.e. Going concerned where we have past track record as well as future trend /orders etc. But in Start ups we have only idea and expected suspects/ prospects. We have not covered the process of registering with authorities and incubation etc or the Taxation matters of Startups. The major focus is on Valuation.

Definition

A startup or start-up is a company or project undertaken by an entrepreneur to seek, develop, and validate a scalable economic model While entrepreneurship refers to all new businesses, including self-employment and businesses that never intend to become registered, startups refer to new businesses that intend to grow large beyond the solo founder. At the beginning, startups face high uncertainty and have high rates of failure, but a minority of them do go on to be successful and influential. Some startups become unicorns; that is privately held startup companies valued at over US$1 billion. Valuation plays a major role for Entry of PE/VC Fund as well as knowing what will be an Exit Value. The below Article draws an attention on Pre-Money and Post Money valuation of Startup.

Valuation of Startup Firm

• PE/VC Firms may invest in mature companies with growth potentials.
• Mature companies are easy to value. They have various methods to value a mature companies. However, DCF becomes cumbersome to be applied on start-up firms. The input data is insufficient and requires many assumptions and adjustments in order to carry out DCF valuation.
• Start-up firms are basically valued by investors on the basis of the perceived return they expect in future from their investments. PE evaluate by looking at the entry and exit multiples of the startup. Entry and Exit multiples are basically multiples of earnings or revenue. Few widely used multiples are P/E multiples or EV/EBITA and EV/Sales multiples. Seed Capital can be arranged by convertible debt (CD) rather than equity. Equity is issued only when a firm has a valuation. CD is the loan extended by investors to the start-up firm that gets converted into equity later on. Exact time frame is not known for conversion, it is assumed to take place when the firm embarks upon growth potential.
• Sometime the time may be specified along with the valuation cap or conversion discount or both. Valuation cap is maximum value for startup at which investors will convert their debt into equity. It is like pre-money valuation of the start up.
• Conversion discount is the discount in the equity value when debt converted into equity. The series of Equity Shares is issued. CD Investors will be issued Series A Equity Shares. Subsequent equity financing post series A will be issued Series B, Series C and so on. Each round of equity financing sets pre-financing valuation of the start-up firm and determines its equity take ownership. In subsequent equity financing, previous equity series holders may sell off their stake and exit, leaving room for new investors.  
• Each investor class comes with an expected return on his investment over the investment horizon. The equity series of funding is possible only when a value can be assigned to the issued capital. Only when start up firm is confident about its valuation, it issues equity rounds of funding. Pre and Post-money valuations will arise due to financing event that takes place with the start up firm.             
• Pre-money valuation is the valuation of the target start up firm before the financing event.
• Post-money valuation is the valuation of the start up firm after the financing event.

If the investor invests an amount of money, say X, and takes y% of ownership stake, then pre and post-money valuations of the start-up firm will be:

• Post Money Valuation = X/y%
• Pre Money Valuation = (X/y% )- X

Higher pre-money valuations make investments expensive for the investor while funds cheap for founder. Lower pre-money valuations make funding very expensive for the founder.

Exit Value (EV) of the PE fund is also known as the terminal value of its investment. It is the selling price of the start-up company in future date. The investors exits at this value. Time horizon can be 5-10 years. EV is placed at a multiple of sales, earnings, or profit using ratios such as EV to sales, EV to EBITA or PE ratio etc. The multiple is determined from standard average of the industry to which company belong.

Conclusion

As such every Valuation method is good in itself as far as inherent value of the On going business is there in the product. It is always better to have a range of value while we value a business instead of keeping stress on valuing a business under one method. It is also necessary to know how much a Business is adding to Economy. One should also take into account the Due diligence input while arriving at the Final Negotiated Value.

The above Presentation is prepared after referring to various books. Although due care is taken, it is prepared for general knowledge purpose and not for specific use. The readers are advised to take proper note of the same and advised to take specific advise before acting on the same. One should not act upon the information contained in this newsletter without obtaining specific professional Advice. Further, no representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this presentation.