The World of Startup Valuations Magic, Mystery or Craft?

AUGUST Valuation Investment Banking Restructuring Advisory Services 2019 Content

1 Foreword 2 Introduction to Start-ups 3 Growth Stages for a Start-up 4 Funding Stages for a Start-up 5 Valuation Methods for valuing Start-ups 5.1. Venture Capital Method 5.2. Berkus Method 5.3. Scorecard Method 5.4. Risk Factor Summation Method 5.5. First Chicago Method 5.6. Backsolve Method 6 Concluding Remarks

The World of StartupValuation Valuations Methods – Magic, for ValuingMystery Start-ups or Craft? 02 FOREWORD

The dotcom bubble of the 2000 was one of the most phenomenal disruption that took place in the history of equity markets. Also known as the internet bubble it was a surge in the prices of stocks in the U.S. primarily pertaining to Internet / Tech companies. This was supplemented by the bull market run around the same time which fueled the upsurge in prices.

From 1994 to 2000 the equity stock of these so called “Internet-Based” Companies grew aggressively 5x-6x. Such exponential growth was driven by the sentimental estimates of analysts/investors that, internet would be the next big thing. Nevertheless, the internet did end up being a phenomenon. However the value expectation may have been slightly over-estimated. The entire episode led to the crashing of NASDAQ with an estimated loss of $ 5 trillion in Market Capitalization. The aftermath being NASDAQ taking 15 years to recover its all time high it once honed at the peak of the dotcom bubble which can be seen in the figure shown below:

NASDAQ INDEX (1975-2015)

8,000 7,000 6,000 5,000 4,000

3,000

2,000

1,000

500

1975 1980 1985 1990 1995 2000 2005 2010 2015

*NASDAQ primarily consists of technology and internet based stocks and hence it was called the “Internet Bubble” Source: macrotrends.net

The World of Startup Valuations – Magic, Mystery or Craft? 03 FOREWORD

internet-companies then, notable similarities exist: extra-ordinary rates of cash burn, colossal losses, ambitious assurances of a steep growth trajectory and feeble due diligence by investors under the fear of missing out. Post the dotcom bubble, the big question which lurks in the

valuations arrived at? There is more than what meets the eye, when it comes to

examples whereby the valuations arrived at by the bankers

company went IPO. Some of them are listed below: Source: in.tradingview.com

car rides, scooters and bicycle-sharing system. The company went public recently. Contrary to popular market expectation, the share price instead of soaring, has been trading below the price at which it opened it’s IPOs.

Similarly in the case of UBER, the company was approached by eminent investment bankers of the Wall Street nine months before its IPO, and a valuation of $ 100-120 billion was proposed. The company hired the bankers to make the valuation a reality. However when the company went public the share prices plummeted and the market capitalization of the company stood at ~ $ 69 billion. It also marked one of the worst falls post IPO debut in the US market history. Recently the company declared a loss of $ 5.2 billion in the second

So what is the reason behind these companies displaying a Source: in.tradingview.com decline in value post the IPO?

of increasing their Return of Income. The protocol followed by them is to exit at the right time when their investments are at

its IPO stage, the same gets assessed by the market and correction takes place. As the valuations are arrived at by a

market holds for the company.

04 The Indian Startup Valuations

From humble beginnings to its most recent valuation of $ 21 billion, Flipkart has become a beacon for every thriving startupreneur. It has been on the headlines for quite sometime after Walmart, the biggest retailer in the world purchased a significant stake in it. However, mind-boggling question that has pinched many analysts remains unaddressed. How exactly was the valuation number arrived upon? 1,352 In INR Bn

970 752 217 730

>661 156 132 421 95

156

28

(4) (8) (5) (2) (21) Mar -14 Mar -15 Mar -16 Mar -17 Mar -18 Mar -19 Total Revenue Profit Valuation As per the article on firstpost.com, since its inception a Economist reckoned e-commerce is just a $15 bn market, decade ago, Flipkart has lost around $ 6.1 billion in cash by much smaller than the Forrester estimate. So Flipkart's 2017, almost equivalent to half the funding raised by them Gross Merchandise Value (GMV) ranges from a little over at that point of time. The accumulated losses of the $7 billion (if you believe The Economist) to $8.6 bn company stood at about $ 3.6 billion as of March 2017, (Forrester). Flipkart does not report GMV and we don't according to its filings in Singapore. have Flipkart's 2017-2018 numbers. But Flipkart's An extract from an article by rediff.com pertaining to standalone filings (excluding Myntra-Jabong) said valuation numbers arrived at by different leading economic revenues (which would be a percentage of GMV) rose 18 spaces has been presented. per cent to Rs 155.7 bn ($ 2.4 bn) in FY2016-2017 from Rs 131.8 bn ($ 1.98 bn) in 2015-2016…. “Forrester Research estimated the online retail revenues (less tickets) were at $19.6 bn in 2016-2017 and $27 bn in Assuming Forrester's estimate of 35 per cent growth is 2017-2018. That's about 35 per cent growth. Forrester reasonably accurate, Flipkart's 2017-2018 revenues should projected 26 per cent CAGR for the next five years which have hit about $3.2 bn. Does that gel with $7 bn to $8.6 bn will depend on fast smartphone and Internet penetration, a as GMV? Hard to tell. (Myntra-Jabong may have logged good per capita income growth and robust fintech $1.2 bn GMV in 2017-2018). The Walmart deal ($16 bn for 77 solutions. Forrester estimated Flipkart's standalone per cent) values Flipkart at $21 bn-plus. Keeping generous market-share (without Myntra-Jabong) was 31.9 per cent error margins given the discrepancies, that is three times in 2017-2018, while Amazon India held 31.1 per cent. But The Economist estimate for GMV and maybe, seven times, Flipkart claimed it held 60 per cent market share… the 2017-2018 revenues. We have no clear idea what the future burn-rate will be.” The Economist estimated Flipkart logged just under 50 per cent of online revenues (less ticketing). That's way more It is quite obvious that it is challenging to decipher the market share than in Forrester's estimates. But The mystery behind startup valuation.

“Of recent, the valuation game has turned into a ‘black magic art’ more than a science”, -Ravi Gururaj, Chairman of Nasscom.

**The total revenue and profit have been extracted from returns filed with the ROC. ^ The valuation numbers have been extracted from various articles from notable news The World of Startup Valuations – Magic, Mystery or Craft? 05 blogs The Indian Startup Valuations

Few other startup valuation based on latest round of funding are as under: In INR Bn

1,107

650 33

455 311 8 6 2 3

(0) (4) (9)

(15) (16)

Mar -14 Mar -15 Mar -16 Mar -17 Mar -18 Mar -19

394 454

244

195 313 22 14 8 4

(8)

(28) (31)

(49) Mar -14 Mar -15 Mar -16 Mar -17 Mar -18 Jan -19

Total Revenue Profit Valuation

**The total revenue and profit have been extracted from returns filed with the ROC. ^ The valuation numbers have been extracted from various articles from notable news blogs : Economic Times, Live Mint, CNBC, Times of India, Tech Crunch among others. #Valuation numbers has been converted from USD to INR based on exchange rate prevalent as on the last day of respective financial year.

The World of Startup Valuations – Magic, Mystery or Craft? 06 The Indian Startup Valuations

Few other startup valuation based on latest round of funding are as under: In INR Bn 228 46

4.68

8.5 1.46

- 0.00 0.24

(0.00) (0.02)

(1.37) (2.05)

(3.97) Mar -14 Mar -15 Mar -16 Mar -17 Mar -18

325

56

5 31 25 1 0 0 0

(0) (0)

(4) (4) (5) Mar -14 Mar -15 Mar -16 Mar -17 Mar -18

Total Revenue Profit Valuation

**The total revenue and profit have been extracted from returns filed with the ROC. ^ The valuation numbers have been extracted from various articles from notable news blogs : Economic Times, Live Mint, CNBC, Times of India, Tech Crunch among others. #Valuation numbers has been converted from USD to INR based on exchange rate prevalent as on the last day of respective financial year.

As it can be seen from the above figures, the valuations are soaring in spite of declining profits.

The World of Startup Valuations – Magic, Mystery or Craft? 07 FOREWORD

Traditionally , the general proposition has been that if a company has been losing money on every transaction it makes, then the business model is not a sustainable one. However this may not hold true anymore given the fact that today the investors look at the long term potential rather than short term gratifications. Similarly, the traditional valuation approaches may not be able to reflect the fair value of these tech-startups. What is the utility that one sees while investing in a startup is enigmatic and subject to infinite number of if and buts. The valuation arrived at of these startups remains a mystery.

Today, the valuation of startup is a plethora of macro & micro factors with a pinch of sentiment:

Valuation = {Founder’s aspirations, Revenue Growth, Technology, Investor fear of missing out, Downside Protection}

At times, investors tend to over/under estimate the fair value of the startups, probably as only a handful are aware as to how exactly these startups would create value and the rest speculate the potential thereof. Every promotor/startuprenuer dreams of making his startup the next big success story. They get so engrossed in fixing a number to their startups, that they are not quite cognizant if their startups have the potential to disrupt the market place or solve problems of the larger mass to actually demand such a high valuation.

The startup space is rapidly growing. Endless rounds of funding, acquisitions and sale of startups are taking place around us. But how is the value determined if one does not share the sentimental attachment and foresight the startpreneur holds. Will valuing a startup remain aMystery to all? Or is it just a Magic number as claimed by many. Or perhaps one may need to be a skilled Craftsman of valuation to decode this number.

A humble attempt has been made in this note to summarize globally acceptable key valuation approaches utilized by PE and VC firms for valuing startups.

The World of Startup Valuations – Magic, Mystery or Craft? 08 Introduction to Start-ups Valuation of Start-up Companies

A startup is a proposition initiated by individual promotors or entrepreneurs to search for a repeatable and scalable business model. Start-ups tend to emerge out of an idea which has the potential to provide solutions to numerous users.

Start ups face high uncertainty and do have high rates of failure, but the minority that go on to be successful companies have the potential to become large and influential

The World of Startup Valuations – Magic, Mystery or Craft? 09 Introduction to Start-ups

Startups tend to have the following characteristics:

Complex capital High operating structure losses Trivial revenue No operational streams history High burn rates

Promoters design startups to effectively develop and validate a scalable business model. Hence, the nuances of establishing a startup and entrepreneurship are quite similar.

As the initial idea conceptualizes into a viable proposition the promoter/startupreneur tends to fund the startup. When the startup has surpassed the idea validation/prototype testing stage, the startupreneur will be required to scale-up his business. Often times than not, it so happens that he will face uncertainty as to how he can fuel the scalability. This is when the startupreneur starts to reach out to investors who can help him bridge the gap between the “where the startup is” to “where it can be”.

Startup Expansion

Growth Exit

The World of Startup Valuations – Magic, Mystery or Craft? 10 Stages of Growth of a Start-up

Following is the Journey, that the Start-up goes through, before a “Start-up Company” shift its gears to a “Growth Company”.

Idea Validation Idea Validation Prototype Minimum viable product

Seed funding Early revenue Self funding Angel Investment

Loyal Series A/B rounds Growth Stage Early traction customer base of VC funding

New Growth Scale Up stage Repeatable user Exit, IPO, M&A Channels

The World of Startup Valuations – Magic, Mystery or Craft? 11 Funding Stages for a Start-up

Startups typically go through a series of 'funding stages'. Their valuations can differ after each round of funding. The usual funding stages are as follows:

Stage-1 : Seed Funding

Typically known as the 'friends and family' round because it's usually people known to the business owner who provide the initial Stage 2: “Round A” Funding investment. But, Seed funding can also come from someone not known to the This is the stage that venture capital firms founder called an 'Angel Investor'. Seed usually get involved. It is when startups Capital is often given in exchange for a have a strong idea about their business and percentage of the equity of the business, product and may have even launched it usually 20% or less. commercially. The “Round A” funding is typically used to establish a product in the market & take the business to the next level.

Stage 3: “Round B” Funding

The startup has established itself but Stage 4: “Debt Funding” needs to expand, either with staff growth, new markets or acquisitions. When a startup is fully established it can raise money through a loan or debt that it will pay back, such as venture debt or lines of credit from a bank.

Stage 5: Mezzanine Financing

Bridge financing is an interim Stage 6: Initial Public Offering (IPO) financing option used by companies and other entities to solidify their short-term position An Initial Public Offering is when the shares until a long-term financing option of a company are sold on a public stock can be arranged. exchange where anyone can invest in the business. IPO opening stock prices are usually set with the help of investment bankers who help sell the shares.

The World of Startup Valuations – Magic, Mystery or Craft? 12 Type of Start-up Funding

Sources of Funding

Business Bootstrapping Crowdfunding Angel Venture Incubators & Bank Loans, Govt Invest-ment Capital Accelerators NBFC Program

Startups approach HNIs, Angel Investors, Venture Capitalists and Private Equities (hereinafter referred to as “Investors”) who have an appetite to take higher risks.

Startup Investors usually invest with an objective to achieve a rate of return which is higher than what the market can offer. They are generally not mandated to receive regular returns as long as the return they receive after a brief period of time is over and above what they would have received by means of compounding the regular return.

Unlike traditional business valuation methods like Discounted Cash Flows and Comparable Company / Transaction Multiple approaches which are used to value already established companies with cash flows that can be estimated with higher level of certainty, valuation of a startup is more of a herculean task as it involves a lot of subjectivity and estimation in the assessing the true potential of the startup.

Modern day startups are usually tech-oriented and possess valuable “intangible assets” where the traditional methods fail to capture these relevant aspects.

The World of Startup Valuations – Magic, Mystery or Craft? 13 Valuation Methods for Valuing Start-ups

There are few methods by which startups are valued by investors and startprenuers even when they have not started to earn any revenue stream. These methods include:

Venture Berkus Scorecard Capital Method Method Method

Valuation Methods

Risk factor First Backsolve Summation Chicago Method Method Method

The World of Startup Valuations – Magic, Mystery or Craft? 14 Venture Capital Method

The Venture Capital Method was first described by Professor William Sahlman at Harvard Business School in 1987 in a case study.

As the name implies, it is used largely by venture capital funds/early stage investors for valuing startup ventures. Typically, an investor will either try to obtain a return on his investment commensurate with the risk he perceives in the venture or will seek to monetize his exit at a certain multiple over and above his investment. The Venture Capital Method helps us to arrive at a fair value after considering the above said requirements by discounting the future value over a given time frame.

The method starts by defining the Return on Investment (ROI) on the investment which is generally in the nature of 25-60% because of the high risk inherent in the startup. The objective of the Investor is to exit on a particular date in the future at a pre-determined ROI. Accordingly, an exit period will be estimated. Next, the current earnings will be projected to the future to arrive at the earnings as on the exit date. The said earnings will then be multiplied by the P/E multiple to arrive at the future value of the startup. The future value of the startup so arrived at as on the exit date is then discounted by the ROI as defined earlier to arrive at the current Post money valuation of the startup.

The World of Startup Valuations – Magic, Mystery or Craft? 15 Venture Capital Method

INR Venture Capital Method Simple Base Case_1 Case_2 Case_3 Case_4 Annual Earnings as on date 5,000,000 5,000,000 5,000,000 5,000,000 5,000,000 Growth in earnings 20% 10% 20% 20% 20%

Number of years to exit date 10 10 15 10 10 Initial Investment by the investor 2,000,000 2,000,000 2,000,000 2,500,000 2,000,000 Required rate of return 40% 40% 40% 40% 50% Annual earnings as on exit date 30,958,682 12,968,712 77,035,108 30,958,682 30,958,682

P/E Multiple 12 12 12 12 12 Future value of the startup 371,504,185 155,624,548 924,421,294 371,504,185 371,504,185 Value of firm 12,843,499 5,380,192 5,942,229 12,843,499 6,442,451

Equity Stake of the investor 16% 37% 34% 19% 31%

Current Shares Outstanding 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Total outstanding shares 1,184,442 1,591,682 1,507,327 1,241,698 1,450,202 Number of shares owned by investor 184,442 591,682 507,327 241,698 450,202 Share price 10.84 3.38 3.94 10.34 4.44

Pre Money Valuation 10,843,499 3,380,192 3,942,229 10,343,499 4,442,451 Post Money valuation 12,843,499 5,380,192 5,942,229 12,843,499 6,442,451

The World of Startup Valuations – Magic, Mystery or Craft? 16 Venture Capital Method Investment over Multiple Tranches

Investments made by the Venture Capital Fund/early stage investor might not be a lump sum amount deployed all at once but broken down into a number of tranches. In such cases, the dilution of shares becomes a more crucial aspect for the investor as well as the promoter since the investment takes place in multiple tranches and accordingly the value of the startup would have changed at such intervals. However, the exit value of the startup would remain intact irrespective of the intervals at which investments made.

The approach is similar to the one mentioned previously. The same steps are followed till we arrive at the future value of the startup. Post that the future value of the investment made by the investor at various dates is computed by compounding it with the ROI expected on the investment made.

Required ownership is ascertained by dividing the future value of investment made at a particular interval by the future value at exit.

With the required ownership so arrived, the incremental shares are ascertained. The investment made as on date is then divided by the incremental share to arrive at per share value of the investment as on date basis which pre and post money valuation can be computed.

The World of Startup Valuations – Magic, Mystery or Craft? 17 Venture Capital Method Investment over Multiple Tranches

INR Particulars Amount Investments made by the Venture Capital Fund/early stage investor might not be a lump sum Annual Earnings as on date 5,000,000 amount deployed all at once but broken down into a number of tranches. In such cases, the dilution of shares becomes a more crucial aspect for the investor as well as the promoter Growth in earnings 20% since the investment takes place in multiple tranches and accordingly the value of the startup Number of years to exit date 10 would have changed at such intervals. However, the exit value of the startup would remain intact irrespective of the intervals at which investments made. Net Income at Exit Year 30,958,682

The approach is similar to the one mentioned previously. The same steps are followed till we PE(multiple) 12 arrive at the future value of the startup. Post that the future value of the investment made by Shares Outstanding Before Investment 1,000,000 the investor at various dates is computed by compounding it with the ROI expected on the Company Value at Exit 371,504,185 investment made.

Shares Outstanding After Final Round 1,109,537 Required ownership is ascertained by dividing the future value of investment made at a particular interval by the future value at exit. Terminal Share Price 331.4

With the required ownership so arrived, the incremental shares are ascertained. The INR Invest- Outstanding Investor investment made as on date is then divided by the incremental share to arrive at per share Investment Required Future Required Outstanding Share Pre-- Money Post-Money Amount ment Return Value Ownership Shares (Pre) Shares Owns No. Price Valuation Valuation value of the investment as on date basis which pre and post money valuation can be Year (Post) Shares computed. Investor/ Tranche A 1,000,000 0 40% 28,925,465 7.79% 1,000,000 1,084,435 84,435 11.84 11,843,499 12,843,499 Investor/ Tranche B 500,000 2 40% 7,378,945 1.99% 1,084,435 1,106,410 21,976 22.75 24,673,258 25,173,258 Investor/ Tranche C 500,000 4 40% 3,764,768 1.01% 1,106,410 1,117,737 11,327 44.14 48,839,586 49,339,586

2,000,000

The World of Startup Valuations – Magic, Mystery or Craft? 18 Berkus Method

Berkus method was first introduced by Mr. Dave Berkus, a renowned author and startup angel investor from California

He mentions that once a company starts generating revenue, this method is no longer applicable, as everyone will use actual revenues to project the value of the startup.

This method is often useful for pre-revenue valuation to a business, that has potential of reaching over $20 million in revenues within five years. The only catch here is the risk involved in estimating whether the startup will be able to achieve a revenue figure above the specified limit mentioned, going further.

If Exists Parameter Add to Company Value up to: Low High Sound Idea Basic Idea $ - $ 500,000 Prototype Reducing Technology Risk $ - $ 500,000 Quality Management Team Reducing Execution Risk $ - $ 500,000 Strategic Relationships Reducing Market Risk $ - $ 500,000 Product Rollout or Sales Reducing Production Risk $ - $ 500,000 Maximum value to be adopted $ - $ 2,500,000

The World of Startup Valuations – Magic, Mystery or Craft? 19 Berkus Method

We have tried attempting to use this method in a slightly different context, wherein we have made a few assumptions and adjustments to the said method to make it more commensurate with the Indian Scenario.

As per the Berkus method the maximum value that can be attributed to the firm is $ 2.5 Million post rollout. The topline to be achieved in the 5th year is $ 20 Million. Accordingly, the maximum value attributable to the firm is 12.5% of its expected revenue in the 5th year.

In a similar fashion if one were to replicate similar methodology in the Indian scenario, one can be expected to project the 5th year revenue of the startup. The maximum value that can adopted will be 12.5% of the said revenue. The value so arrived can be divided by 5 to account for the parameters mentioned in the Berkus method.

INR As per Berkus method Revenue to be achieved in 5 years 20,000,000 Maximum value to be adopted 2,500,000 Maximum value as a % of Sales 12.5%

From an Indian Context Revenue expected in 5 years 300,000,000 Maximum value @ 12.5% of Sales 37,500,000

INR If Exists Parameter Maximum 0 1 2 3 4 5 value 0% 20% 40% 60% 80% 100% Total Sound Idea Basic Idea 7,500,000 ✔ 3,000,000 Prototype Reducing Technology Risk 7,500,000 ✔ 4,500,000 Quality Management Team Reducing Execution Risk 7,500,000 ✔ 6,000,000 Strategic Relationships Reducing Market Risk 7,500,000 ✔ 1,500,000 Product Rollout or Sales Reducing Production Risk 7,500,000 ✔ 3,000,000 Maximum value to be adopted 37,500,000 18,000,000

The World of Startup Valuations – Magic, Mystery or Craft? 20 Score Card Method

We have tried attempting to use this method in a slightly different context, wherein we have Scorecard method also known as Bill Payne’s method, is one of the most prevalent method made a few assumptions and adjustments to the said method to make it more used by angels to value an early stage start-up. commensurate with the Indian Scenario. This method gives more weightage to the quality of the startup as of today rather than the As per the Berkus method the maximum value that can be attributed to the firm is $ 2.5 uncertain sales which it can generate in the future Million post rollout. The topline to be achieved in the 5th year is $ 20 Million. Accordingly, the maximum value attributable to the firm is 12.5% of its expected revenue in the 5th year. However, it is not free from bias as the value is more or less dependent on the judgement of the valuer. In a similar fashion if one were to replicate similar methodology in the Indian scenario, one can be expected to project the 5th year revenue of the startup. The maximum value that can The philosophy behind the said method as described by Mr. Payne is that “in building a adopted will be 12.5% of the said revenue. The value so arrived can be divided by 5 to account startup, the quality of the team is paramount to success. A great team will fix early product for the parameters mentioned in the Berkus method. flaws, but the reverse is not true.”

The method requires one to first arrive at a range of comparable companies across similar sectors for which pre-money valuation has already been arrived at.

Post that, the startup to be valued is benchmarked against the comparable companies selected in a scorecard which constitutes of certain metrics carrying pre-assigned weights provided by Mr. Payne as shown in the figure.

Scores are given against the metrics. (1 being average, <1 being below average and >1 being above average). The said scores are multiplied with the corresponding weights to arrive at a weighted average factors (Adjusted factor)

The adjusted factor so obtained is multiplied by the average/median pre-money valuation of the said comparable companies to arrive at the value of startup.

The World of Startup Valuations – Magic, Mystery or Craft? 21 Score Card Method

Your Venture’s Value Driver Weight Factor Comment Score Strength of the Management Improvement 30% 0.9 0.27 Team needed Size of the Opportunity 25% 1.25 0.31 Achievable Product/Technology 15% 1.25 0.19 Patented Competitive Environment 10% 1.6 0.16 Less Competition Marketing/Sales Weak sales 10% 0.3 0.03 Channels/Partnerships network Need for Additional 5% 0.12 0.01 High Investment Other 5% 1 0.05 Average 100% 1.02

INR Comparable Company Pre-M- oney Valuation A 23,000,000 B 42,000,000 C 12,000,000 D 6,000,000 E 13,000,000 Average 19,200,000 Adjusted factor 1.02 Pre Money Valuation of your venture 19,507,200

The World of Startup Valuations – Magic, Mystery or Craft? 22 Risk Factor Summation Method

Risk factor summation method can be described as a combination of both Scorecard as well as the Berkus method, mentioned previously. This method was first described by the Ohio TechAngels which considered a much wider set of risk factors in arriving at a pre-money valuation giving regard to qualitative factors intrinsic in the start-up.

The Ohio TechAngels describe the method as “Reflecting the premise that the higher number of risk factors, then the higher overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit.”

Accordingly, there are 12 risk parameters provided to assess the start-up. The parameters are given a range of points from -2 to +2 as shown below, based on the startup’s evaluation of where it stands.

-2 being the lowest and +2 being the highest. As per Ohio TechAngels, the average pre-mon- ey valuation is then adjusted by $250,000 for every “1” point. However the basis for the above said $250,000 same has not been provided.

The method starts off by using a pre-determined pre-money valuation number already arrived at for the said startup. Post that the startup is subjected to assessment using 12 parameters as shown, basis which points are allotted against the said parameters. Finally, the points are summed up and multiplied by the value so determined between the investor and the startup.

Lets say the investor and investee come to an understanding that the parameter value to be assigned to “Point-1” is 1.25% of revenue. Accordingly, in the example shown (2,500,000 X1.25%) comes out to be INR 31,250. The above said methodology is applied to arrive at the risk adjusted pre-money valuation of the startup.

The World of Startup Valuations – Magic, Mystery or Craft? 23 Risk Factor Summation Method

Factor for growing the company and exiting it Points Very Positive 2 Positive 1 Neutral 0 Negative - 1 Very negative - 2

INR Risk Factor Rating Value Comment Management 2 62,500 Very Efficient Stage of the startup 1 31,250 Prototype functions Legislation/Political risk 1 31,250 Low Manufacturing risk -2 (62,500) Subject to Government Norms Sales and marketing risk 1 31,250 Good sales team in place Funding/capital raising risk 2 62,500 Low Competition risk 0 - Average Technology risk Subject to technological -1 (31,250) obsolescence Litigation risk Alternative of Patented technology -1 (31,250) exists International risk 1 31,250 Low Reputation risk -2 (62,500) Individual entity Potential lucrative exit 2 62,500 Buyers in the market exist Risk Summation 4 125,000

INR Particulars Value Revenue 2,500,000 Multiplier 12 Pre-Money valuation 30,000,000 Risk Summation (125,000) Risk Adjusted Pre-Money valuation of the startup 2,875,000

The World of Startup Valuations – Magic, Mystery or Craft? 24 First Chicago Method

The First Chicago Method was developed by, and consequently named for, the venture capital arm of the First Chicago bank, the predecessor of firms Madison Dearborn Partners and GTCR, leading private equity companies. It is a hybrid between Discounted Cash Flow and Multiple-based approach, as it tries to capture the risk involved in projections of future cash flows at various scenarios being “Best case”, “Worst case” and “Base case”.

In such an analysis a “Base case” is built whereby the most realistic and practical assumptions are taken to draw a set of future cash flows. Next a “Best case” scenario is modelled to reflect the more aggressive cash flows the startup envisages to achieve. Similarly, a “Worst case” scenario is also formulated which reflects the most conservative future cash flows the company expects to receive.

The method starts off by developing different set of cash flows with respect to each scenario till the exit date as intended by the investor. Next, a divestment price ie terminal value is modelled by assuming an exit multiple consistent with the scenario in question. The cash flows and terminal value are then discounted using the investor’s return on investment to arrive at the valuation of the startup under that particular scenario.

Finally, a probabilities are defined for different scenarios mentioned above. The startup value arrived under various scenarios is multiplied by their respective probabilities to conclude one single probability weighted value for all scenarios.

Particulars Best Case Base Case Worst case Value of the startup 2,650,000 1,338,021 195,375 Probabilitiy 30% 60% 10% Weighted Average value 1,617,350

The World of Startup Valuations – Magic, Mystery or Craft? 25 First Chicago Method

INR Base case Pariculars Year 1 Year 2 Year 3 Terminal value Revenue 1,000,000 1,100,000 1,210,000 Expenses 900,000 957,000 1,028,500 Earnings 100,000 143,000 181,500 P/E multiple 10 1,815,000 Free cash flows 100,000 143,000 181,500 1,815,000 Present values 83,333 99,306 105,035 1,050,347 Value of startup 1,338,021

Best case Pariculars Year 1 Year 2 Year 3 Terminal value Revenue 1,000,000 1,200,000 1,440,000 Expenses 800,000 924,000 1,080,000 Earnings 200,000 276,000 360,000 P/E multiple 10 3,600,000 Free cash flows 200,000 276,000 360,000 3,600,000 Present values 166,667 191,667 208,333 2,083,333 Value of startup 2,650,000

Worst case Pariculars Year 1 Year 2 Year 3 Terminal value Revenue 1,000,000 1,020,000 1,040,400 Expenses 950,000 989,400 1,019,592 Earnings 50,000 30,600 20,808 P/E multiple 10 208,080 Free cash flows 50,000 30,600 20,808 208,080 Present values 41,667 21,250 12,042 120,417 Value of startup 195,375

The World of Startup Valuations – Magic, Mystery or Craft? 26 Backsolve Method

One of the lesser known valuation methodology used in startup valuation is the Backsolve method which is a variant of Option Pricing Model.

The Backsolve method uses Black-Scholes-Merton option pricing equation to estimate the value of the startup.

The first step involves determining the claims on the equity value and the resulting “breakpoint” at which different securities would benefit.

Preference stock Common stock Common Options Number of shares 2,000,000 400,000 100,000 Purchase (or exercise) price 1 0.3 Liquidation price 1.00x Liquidation preference 2,000,000

As seen in the table, the Preference shares will hold liquidation preference or seniority claim over common stock. As the common options won’t be exercised till they meet the conversion price of INR 0.3, common stock will hold the next preference. Once the price breaches exercise price of INR 1, common stock along with options and preference shares will be participate.

The Risk free rate, Volatility of comparable companies and expected time to exit from the startup is ascertained. These will be used as inputs for Black-Scholes-Merton Model.

The total option value for each set of instrument is determined and per share value for each instrument is ascertained.

The exercise is repeated iteratively till the value per share of the instrument which was recently issued/raised matches with the value per share derived by using the Backsolve model.

The World of Startup Valuations – Magic, Mystery or Craft? 27 Backsolve Method

From To Liquidation preference - 2,000,000 Prefered Stock Only 2,000,000 2,120,000 Common stock only 2,120,000 2,620,000 Common options exercised 2,620,000 Infinity Preferred Stock Converts to Equity

Scenario 1

Total Equity value 4,000,000 Risk Free rate 7.80% Volatality 50% Time to exit in years 8 INR From To Option value Incremental Option value - 2,000,000 3,166,482.7 833,517 2,000,000 2,120,000 3,129,152.3 37,330 2,120,000 2,620,000 2,983,954.1 145,198 2,620,000 Infinity - 2,983,954 4,000,000 INR From To Preference Stock Common Stock Common Options - 2,000,000 833,517 - - 2,000,000 2,120,000 - 37,330 - 2,120,000 2,620,000 - 116,159 29,040 2,620,000 Infinity 2,387,163 477,433 119,358 Total 3,220,681 630,922 148,398 Value per share 1.61 1.58 1.48

The World of Startup Valuations – Magic, Mystery or Craft? 28 Backsolve Method

Scenario 2

Total Equity value 3,000,000 Risk Free rate 7.80% Volatality 50% Time to exit in years 8 INR From To Option value Incremental Option value - 2,000,000 2,228,387 771,613 2,000,000 2,120,000 2,196,238 32,149 2,120,000 2,620,000 2,072,723 123,515 2,620,000 Infinity - 2,072,723 3,000,000 INR From To Preference Stock Common Stock Common Options - 2,000,000 771,613 - - 2,000,000 2,120,000 - 32,149 - 2,120,000 2,620,000 - 98,812 24,703 2,620,000 Infinity 1,658,178 331,636 82,909 Total 2,429,792 462,596 107,612 Value per share 1.21 1.16 1.08

The World of Startup Valuations – Magic, Mystery or Craft? 29 Backsolve Method

The backsolve method is iteratively undertaken till the value per share of preference stock which was the latest issue matches with the value per share arrived using backsolve model. The same takes place is scenario 3, wherein the equity value of the Company comes to INR 2,455,964 and the value of preference stock matches with its issue price.

Scenario 3

Total Equity value 2,455,964 Risk Free rate 7.80% Volatality 50% Time to exit in years 8 INR From To Option value Incremental Option value - 2,000,000 1,731,161 724,802 2,000,000 2,120,000 1,702,630 28,532 2,120,000 2,620,000 1,593,997 108,632 2,620,000 Infinity - 1,593,997 2,455,964 INR From To Preference Stock Common Stock Common Options - 2,000,000 724,802 - - 2,000,000 2,120,000 - 28,532 - 2,120,000 2,620,000 - 86,906 21,726 2,620,000 Infinity 1,275,198 255,040 63,760 Total 2,000,000 370,477 85,486 Value per share 1.00 0.93 0.85

The World of Startup Valuations – Magic, Mystery or Craft? 30 Concluding Remarks

In Professor Aswath Damodaran’s words “Valuation is not just a number, there’s a story to it. The dynamics of valuation process keeps changing based upon the stage of development of the company from idea validation, seed stage, growth stage and while it scales up. As the startup becomes more and more mature its value also keeps increasing accordingly until it reaches a stage of stagnation”.

Practically speaking a lot of factors determine the valuation of a startup arrived at. Some of them being traction in the market, distribution channel, intangibles owned, potential of the industry, number of players in the industry etc. A startup may also be able to achieve a higher valuation based on the innovative and ever-developing business model it comes up with, which gives it the leverage to address issues that is the need of the hour.

In some cases, the valuation sores up due to negotiation/demand for a stake in equity etc., between investors. As the value is negotiated between only a handful of investors there is a high probability that the startup maybe overvalued.

Valuation also depends on to the time span between which the startup raises funds. Overfunding in quick successions may hike up the value initially but after a point it may backfire when the startup is not able to deliver results as envisaged.

There is no foolproof methodology for valuation of a startup. It changes from one startup to another depending on the type, stage of growth, sector the startup belongs to and many more factors. One must use judgement and undertake due diligence before one can try assessing the value of the startup.

One thing remains constant, is the fact that the valuation will always be derived by the utility what it holds in the eyes of the beholder.

To conclude, in Warren Buffett’s words, “Price is what you pay and value is what you get”.

The World of Startup Valuations – Magic, Mystery or Craft? 31 Contact US

Management

Rajeev R. Shah Manish Kaneria Ravishu Shah Managing Director & CEO Managing Director & COO Managing Director - Financial Advisory Services +91 79 4050 6070 +91 79 4050 6090 +91 22 6130 6093 [email protected] [email protected] [email protected]

Project Leader

Sumit Kumar Nitin Mukhi +91 80 4152 8593 +91 79 4050 6073 [email protected] [email protected]

Research Analysts

Jaison Dsouza Aayushi Singhania +91 80 4152 8593 +91 80 4112 8593 [email protected] [email protected]

India Offices

Mumbai Delhi Bengaluru Ahmedabad Kolkata 1121, Building No. 11, 2nd Floor, 2nd Floor, IAPL House, 104, 1st Floor, Sufiya Elite, 912, Venus Atlantis 9th Floor, KAHM Tower, Solitaire Corporate Park, 23 South Patel Nagar, # 18, Cunningham Road, Corporate Park, 13, Nellie Sengupta Sarani, Chakala, Andheri Kurla Road, New Delhi - 110 008 Near Sigma Mall, Anand Nagar Road, Kolkata - 700 087 Andheri (E), Bangalore - 560 052 Prahaladnagar, Tel: +91 11 2580 2300 Tel: +91 33 4603 4731 Mumbai - 400 093 Ahmedabad - 380 015 +91 99585 62211 Tel: +91 80 4112 8593 Tel: +91 22 6130 6000 +91 97435 50600 Tel: +91 79 4050 6000

Global Offices

Singapore Dubai 105 Cecil Street, 2001-01, Level 20, # 22-00 The Octagon, 48 Burj Gate Tower, Singapore - 069 534 Downtown, Sheikh Zayed Road, PO Box 29734, Dubai, UAE Tel: +65 8589 4891 Email: [email protected] Tel: +971 4 518 2608 M: +971 52 617 3699, +971 52 382 2367 Email: [email protected]

The World of Startup Valuations – Magic, Mystery or Craft? 32