Valuation Basics

There are many options to value a startup from DCF model (Discounted Cash Flow), VC method, Peer Multiples to Scorecard approach. While working on valuation multiples help generally in Series rounds, At early seed and angel stages, the methodology used is mostly on sales and revenue rates.

Early valuation Advisor(EVA)Leverage the EVA to get a sense of your valuation based on the revenue number. 

In high growth and rapidly growing startups, the trajectory of margins and revenue can be used to demand multiple based valuation of future sales( 5X or 12 X). Case 1: Let's assume, A startup that is rapidly acquiring customers and doing a good job of retaining them as well and is projected to achieve INR 10 million in sales in next 12 months may set its Pre-money valuation at around INR 5O million (i.e. 5x of 10 million, e.g.). Pre-money valuation is simply the valuation of the company as it stands before raising new capital or any additional financing. Case 2: Another method for startup valuation  can be using the VC method.Please refer to the tool EVA which used this method. This looks at future revenue at the time of exit of the VC. This will consider the P/E for a comparable industry. It arrives at pre money and post money valuation using this method. Lets say the VC is expecting to exit on 7 years  At exit, company would have revenue of INR 3 billion, at certain % growth rate of revenue Price to earning for comparable industry is at 10. The company is looking to raise 200 million. Investors (VCs/Angels) uses the target rate of return to calculate the present value of the projected terminal value. The target rate of return is typically very high (30-70%) in relation to conventional financing alternatives. In the above case if A VC firm expects to make return upwards of 70% then the POST money valuation based on terminal value would be INR 731, 103, 402 for a equity stake of 27.38% Case 3: There is another way that the VC applies a Scorecard framework where 5 or more factors are valued individually and then added up to arrive at an overall multiplier, which is then applied to a comparable market transaction. 

ExampleThis analysis can include factors such as:

  1. Team: Skill, Experience and Education

  2. Market Size and potential

  3. Market Competition

  4. Technology Leverage

  5. Distribution Strategy 

 Case 3: The VC would then assign ratings or weight to each of the factors under consideration and related position of the startup compared to peers in each of the factor categories. Each VC may assign a different weight based on its view of potential for success some VCs may weight team quality above opportunity size and vice versa.

Sample Scorecard breakdown A comparative factor based analysis  for each category is derived by multiplying the rating and relative value of the startup under consideration. For example, In the above case it appears the startup is relatively better positioned compared to peers in team quality, opportunity size and offering quality while the VC has assigned a relatively weaker position compared to market in areas of competitive pressure, marketing/distribution and customer feedback. Adding up all the factors, the transaction or valuation multiple comes out to 1.12x. Assuming recent and comparable peers have raised funding in the ballpark of INR 40 million (list all transactions and compute average of capital raises), then the Pre-money valuation for this startup would be INR 44.8 million (i.e. 40 million x 1.12). Note the Scorecard valuation approach resulted in a meaningfully lower valuation, i.e. INR 44.8 million in case 3 as compared to Sales Multiple approach by the company, i.e. INR 50 million in case 1.  Each valuation technique arrives at a different number more often than not.  Let’s now get to the investor roadshow. Suppose this startup is seeking INR 20 million in capital in its  round and a VC is willing to accept the INR 80 million Pre-money valuation set by company management. We then arrive at Post-money valuation using the following simple formula: Pre-money valuation + Series A funding = Post-money valuation

80 million + 20 million = $100 million Post-money valuation.

Therefore, an investor would inject INR 20 million for a 20% equity stake in the startup, i.e. (20 million / 100 million) x 100%. Valuation at early stage in a negotiation game. Only actual negotiations reveal what the valuation walk-away points are for investors and founders but the above exercise illustrates how existing shareholders including founders and Angel investors may get diluted more than expected should their Pre-money valuation figure become somewhat indefensible. The investor has to be sold on your assumptions for valuation and if you genuinely believe you are being lowballed on valuation by the investor then you should walk away from the transaction.  It is good to have the following worked out well before you're on the road looking to raise funds. Optimistic Case: Maximum valuation at which you think your company could be valued. This is rarely an issue as investor are well versed but it is good to have an optimistic view Walkaway Case: This is the minimum where you would walkaway from the deal . Run your assumptions well with your co-founder and have yoru mentor also give you a feel. It is good to have industry veterans guide you. Most investors are reasonable and will give your position a thorough review but you have to research your assumption and arrive at a standard methodology based valuation.

How to maximize your startup’s valuation?

As pointed before, the VC would try its best to pick more exponential winners in its portfolio and may use the following questionnaire to short list a startup. The same list of questions may also help decide the multiple range for computing your startup’s valuation. The starting point for a founder is to start with high level market analysis based on recent deals in the market: Know your domain/industry comparable and competitors. Identify the key players in your industry, both in local and foreign markets.If you are a SaaS startup in healthcare industry India, Go through recent deals to know what is the valuation point on how many customers etc.. Create a spreadsheet of at least 5 -10 comparable and get rid of the outliers. Get as much information as you can about their burn rates, runways, operating margins, revenue, valuations, etc. Understand their funding rounds as a function of these metrics. Identify the main drivers of the industry. Why does X company have a higher valuation? Why does Z have a lower one? Look at what factors and metrics affected those valuation spreads, and finally set a target valuation for your company. A multiple is about capturing the story — the better the story (not a fable but in reality) the higher a VC would be willing to pay. There is a 25% valuation difference between an 8x story vs. a 10x story. The more boxes the VC checks in reviewing your pitch, the better your prospects for “multiple expansion.” Ask yourself the following questions and see how many you can respond to with confidence:

Real market need

  1. Is the opportunity disruptive enough to attract future investments from other early stage investors?

Large opportunity

  • How well does the offering compete or even better is there a Blue Ocean opportunity (i.e. there is limited to no competition)?

  • What is the company’s “unfair” competitive advantage? Technology? Patent? Team? Relationships?

  • Is the business model pivotable within a reasonable period? Businesses that can adapt live to fight another day, another market trend.

Is the business model high margin or mass-volume dependent?

Is the revenue composition more one-time or recurring in nature?

  • Does the team have a solid feel for metrics driving company valuation? Average Revenue Per User (ARPU), Contribution Margin, Customer Acquisition Cost (CAC), Retention rate, Monthly Recurring Revenue (MRR), Life Time Value (LTV) analysis?

  • Are there opportunities to significantly increase ARPU or Revenue per Unit, by adding security features or mobile functionality, for example?

As can be deduced from the above list, valuation for a startup would benefit if the business model has high sales growth expectations, high margins, high revenue visibility, high customer stickiness, large market size, flexible pivot options and most importantly, a top class team. Keep all of these story elements in mind and don’t leave anything on the table. Even if you presently don’t find yourself giving profound and factual answers to the above, be mindful of how integrate thoughts around this list into your future pitch.

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