In
Hindi, there is a saying, “Ek vriksh may anak varshao ka paani hota hai, aur vo
bahut chunotiyo se guzarta hai”, same like an entrepreneur. From starting a
small company (or a startup) to its journey being a successful company, it has
experienced many ups-and-downs. However, the major challenge any startup faces
is of investment and for that, they forage for the investor. Now talking from the
investor’s point of perspective the challenge for him is to identify the
valuation of the startup and invest accordingly because startups have little or
no profits or revenue and less than certain futures and hence doing valuation
for them is a bit tricky.
For
big, mature and listed company with steady earnings and revenues, it is done by
valuing them on the basis on their Earnings before Interest, Taxes,
Depreciation and Amortization (EBITDA) or based on other industry-specific Multiples.
However, it is more difficult to value as a new venture that is years away from
sales and is not listed yet.
For
an entrepreneur, who is trying to raise capital for his startup, or thinking of
putting money into one, it is important for him to determine a company’s worth.
To evaluate a startup we have the following methods: -
- Cost-to-Duplicate
- Market Multiple
-
Discount Cash Flow (DCF)
1.Cost-to-Duplicate
This approach is used to determine the fair market value of the startup by looking
at the physical assets. By the means of this approach, we calculate how
much it would take to build another company just like this startup from
scratch. The key point here is, a smart investor would not invest more than it
would cost to duplicate it.
Talking
about the information technology sector, the cost-to-duplicate a software business
might be figured as the total cost of developing software. For a
high-technology startup, it may be a cost associated with R&D, prototype
development and patent protection. Since it is objective, it is often seen as a
starting point for evaluating a startup because it is based on empirical,
historic expense records.
The
major drawback of this approach is that it does not tell you about the
company’s potential for generating revenues. Moreover, this approach also does
not cover intangible assets. It is often used as a “lowball” measure of company
value because it predominantly underrates the venture’s worth. When intellectual
capital forms the basis of the firm, physical infrastructure and equipment is a
small component of the actual worth.
2.Market
Multiple
This
is the favorite approach of Venture Capitalist, as it facilitates them by
providing insights into the market that how much market is willing to pay for the
company. Market multiple techniques value the company based on recent accession
of indistinguishable companies in the market.
To
value a firm at the infancy stages, substantial prognostication must be done to
gauge what the sales or earnings of the business will be once it attains the
mature stage. Investors often provide funds to startup when they believe in the
business model of the firm and in the product that they are going to deliver,
way before they start generating revenues. Valuation of a startup is done on
the revenue multiples however, valuation of well-established corporations is
based on their earnings.
The
Market multiple techniques estimate the value that comes close to what
investors are willing to pay. The startup market is not always easy to find
companies that are closely related to each other. Moreover, for the
unlisted-companies that represents the closest comparisons there deal’s terms
and conditions are often kept under swathe by initial juncture.
2.Discount
Cash Flow (DCF)
This
technique deals with the forecasting of how cash flow much the company is going
to produce in the future, and then via expected rate of investment return,
calculating how much cash flow is worth. Higher risk involvement leads to the higher
discount rate because there is a doubt that the company will inevitably fail to
generate sustainable cash flow.
The
problem with this technique is that it depends upon the analyst’s capability
and competency to predict the future market conditions and make accurate
predictions about the long-term growth rates. In many of the cases, predicting
earnings and sales after a few years mealy becomes a guessing game. In
addition, the value generated by the DCF technique is eminently sensitive to the
expected rate of return used for discounting cash flows. Hence, this technique
needs to be used with much care.
Hence,
because of the uncertainty of success or failure, it is very difficult to value a
company accurately in its infancy stage. There is a saying that, “Startup
valuation is more of an Art than a Science”. There is a lot of truth to that.
Customers
of start-ups:
We
are now seeing a whole new breed of Indian startup unicorns emerging, 2019 seems to be on track to beat
2018’s record-breaking tally. Since the start of 2019, seven start-ups have
reached unicorn status already. But not all of these were expected. Some have
jumped the queue to overtake others. During 2016, there was about 10
unicorn startups, within 3 years, we have 25 unicorn startups. These are primarily
due to more and more customer tractions and stickiness. For instance, zomato
gold subscription has 170k customers in 2018 which has increased 5x times to 1
million in 2019. These are primarily due to an increase in geography spread and
more attractive offers and hotel tie-ups enabling customers to remain engaged in making a loyal customer base. A
proactive approach, when smartly executed will always pay off.
-Lakshmi & Aashish