Brief Overview
Valuing an Early stage company is rather difficult due to lack of solid previous data and financials to forecast future performance. It is very difficult to arrive at the true value of the company. Many entrepreneurs especially those from the non financial background claim , “if it’s difficult to arrive at the correct valuation , then why do the exercise at the first place? ” :
We would like to divide the answer in two parts:
- When the company seeks funding, if not directly it indirectly arrives at a value. For example , if the investor is ready to invest 10 Crores in your venture for a 20% stake , the company is indirectly getting valued at 50 Crores (10 Cr / 20% ) . So whether you like it or not, there can be no funding without valuation
- If the founder is unaware or unsure about the value of its company , there would be no room for negotiation and chances are that the founder would end up diluting more stake than he would like to. Continuing the above example, say the founder applies a particular valuation method and arrives at an Enterprise Valuation of 75 Cr. This acts as an anchor for driving the negotiation wherein the founder can ask for 15 Cr ( 20% of 75 Cr) for 20% of its Company as against the 10 Cr the Investor is willing to Invest for the same percentage of equity.
Challenges Faced when Valuing an Early Stage Company
- Information Constraint – Historical financial statements ,past history in terms of earnings and market prices, Comparables- peers/competitors
- Negative Earnings
- A young firm does not have significant investments in land, buildings or other fixed assets and seem to derive the bulk of its value from intangible assets.
- They are far earlier in their life cycles than established firms and often have to be valued before they have an established market for their product
- The value of a firm is still the present value of the expected cash flows from its assets, but those cash flows are likely to be much more difficult to estimate.
- The firm has little in terms of current operations, no operating history and no comparable firms. The value of this firm rests entirely on its future growth potential. Valuation poses the most challenges at this firm, since there is little useful information to go on.
Solutions:
Despite the constraints , there are valuation methods designed to arrive at a value:
Early Stage Companies are generally seeking for either of this stage of Funding
- Seed Funding – Typically known as the ‘friends and family’ round because it’s usually people known to the business owner who provide the initial investment. But, Seed funding can also come from someone not known to the founder called an ‘Angel Investor’. Seed Capital is often given in exchange for a percentage of the equity of the business, usually 20% or less.
- Round A Funding – This is the stage that Venture Capital firms usually get involved. It is when startups have a strong idea about their business and product and may have even launched it commercially. The Round A funding is typically used to establish a product in the market and take the business to the next level, or to make up the shortfall of the startup not yet being profitable
Valuation methods would slightly differ based on the stage of funding and for the purpose of ease we have arrived at suitable methods which can be used:
Generally Accepted Valuation Methods:
- Venture Capital Valuation
The earnings of the private firm are forecast in a future year, when the company can be expected to go public. These earnings, in conjunction with a price-earnings multiple, estimated by looking at publicly traded firms in the same business, is used to assess the value of the firm at the time of the initial public offering; this is called the exit or terminal value. Alternatively, you could forecast revenues for the firm in a future year and apply a revenue multiple to estimate terminal value.
For instance, assume that you are valuing Nexus Tech, a tech firm that is expected to have another round of funding in 3 years and that the net income in three years for the firm is expected to Rs 5 Crore. If the price-earnings ratio of publicly traded software firms is 15, this would yield an estimated exit value of Rs 75 Crore. This value is discounted back to the present at what venture capitalists call a target rate of return, which measures what venture capitalists believe is a justifiable return, given the risk that they are exposed to. This target rate of return is usually set at a much higher level than the traditional cost of equity for the firm.
Using an example, if the venture capitalist requires a target return on 30% on his or her investment, 75 Cr will be discounted to arrive at present value
75 Cr Discounted Terminal value for Nexus Tech is 34.14 Cr
2. Discounted Cash Flow Method
In simple terms, discounted cash flow is the present value of future cash flows that the company is going to generate.
We generally divide DCF method onto following key parts:
- Projected Cash Flows:
Future Cash flows are required to be estimated. For this purpose, it is imperative to establish the KPI’s that is the key performance indicator. For Example, for a digital startup , the number of active users can be a KPI which can translate into revenue. Once the KPIs’ are identified , future free cash flows will be established after making adjustment for working capital and investment requirement.
- Growth Rate:
Growth rate needs to be estimated and the growth can be different at different stages of the company. The most crucial estimation is the growth rate for the determining the terminal value. Terminal Value is the valuation of the business at the end of the projection period.
- Discounting Factor:
In essence the WACC is a percentage and is (in the context of valuating a startup) a way to define the risk an investor is taking when he/she invests in a firm. The higher the WACC percentage, the higher the risk and the lower the valuation of your firm. As investing in startups is risky to begin with, it is not strange to see high WACC percentages for such firms.
3. Market Comparables Method: This method takes valuation estimates with reference to other comparable companies and their market capitalization. Under this approach , the early stage company is required to identify company that has a similar product and is at a similar stage. However if the startup is unique it becomes difficult to identify comparables . In such cases, adjustment needs to be made based on the available comparable.
4. Investor Specific Valuation Method:
Certain Investor have a predetermined basis for determing value, the key indicators generally are:
- Strength of the management team: founders’ experience and skillset, founders’ flexibility, and completeness of the management team.
- Size of the opportunity: market size for the company’s product or service, the timeline for increase (or generation) of revenues, and the strength of competition.
- Product or service: product/market definition and fit, the path to acceptance, and barriers to entry.
- The sales channel, stage of business, size of the investment round, need for financing, and quality of business plan and presentation.
A business owner should not stop with one approach. Angel Investors and business owners will want to use several methods because no single method is useful all of the time. Multiple methods also help a startup determine an average valuation.
Finding this average valuation is important because none of the startup valuation methods are scientifically or mathematically accurate, they are all based on predictions.
Closing Remarks:
While Technically Speaking , Valuation requires a lot of fine tuning and key adjustments to be made, the bottom line is to convince the Investor on the Value being true and coherent to the business it shall achieve over its life cycle.
Valuation is often confused with a mathematical exercise, but in reality it’s the most dynamic dimension to an investment which anchors the entire deal.
Also for statutory purpose in India, its imperative to have valuation done as per Companies act 2013 and Income Tax Act 1961 on infusion of investment in the business , which is a different ball game altogether. This issue will be dealt in a separate article.