How to do Startup Valuations?

Time and again startup founders have approached us saying that they simply cannot place one number to their valuation. The founder says it should be $5M, an advisor says it should be $3M and an investor says it should be $1M. Truth is, startup valuations can indeed be quite tricky, arbitrary and subjective. But this doesn’t mean that it should all be left to luck or driven solely by investors. In fact, our recommendation to founders is always to have a thorough understanding of why and how much they are valued at (or a range thereof), before approaching the deal table. More often than not, investors try to push down the price at which they’re grabbing a stake in the startup, and therefore, having access to information is key to the negotiation process. It is the information asymmetry that makes the valuation vary, creates multiple perception of your startup’s value and gives the investor an upper hand at the deal table.

So how can you take back control and stop investors from dictating the outcome of negotiations? How can you solve for the information asymmetry and increase your chances of raising funds at the valuation that you feel is best for your startup?

Adopt not just 1, but 2 or 3 valuation methodologies

Adopting multiple methods helps you to consider different perspectives and base your valuation on different factors (like projected revenue, projected EBITDA, projected cash flows, etc.) that affect your startup’s value. No two methods will be dependent on the same factor/parameter, thereby reducing the dependence on key assumptions like projected revenue, and in the process allowing you to develop a range of valuations. Here’s an example:

The range of valuations also helps founders to have a reference point during their negotiations, the lower end of the range being the bare minimum value that they must seek for their startup.

So how to do these valuations and how does it differ from valuation of an established company?

Let’s break this down:

1. Which valuation methods are best suited for valuing Indian startups?

   While there are several methods that surface online on google or chat gpt, the criteria to choose the ones suitable for a startup should be:

   a. methods that are widely accepted; and

   b. methods that are practical in terms of availability of inputs

   Here are the top 6 methods that are usually suggested for startups in valuation materials/online content, and our take on them:

   1. Discounted Cash Flow (DCF) Method – most commonly used valuation methodology to value companies, big or small. For startups DCF based valuation should always be carried out, as numbers cannot lose importance, but it should not be the sole method, as projections can be quite arbitrary in early stages.

   2. Comparative Transaction Multiple (CTM) Method – this method should always be used in combination with other methods like DCF and VCM, as it helps in sanity check of the valuation under DCF. After years of experience in startup valuations, we have created an adapted and more practical way of carrying out valuation under this method (discussed in detail later in this article), which is more suited for startups.

   3. Venture Capital Method (VCM) - this method also helps in sanity check of the valuation under DCF and therefore should always be used in combination with other methods like DCF and CTM.

   4. Bill Payne’s Method (BPM) or Scorecard Method – unlike the preceding 3 methods, BPM is a subjective method i.e. it may differ based on the reader’s perception of the startup’s strengths vis-à-vis its industry peers. For a detailed guide on startup valuation under this method, you can refer to our detailed write-up here.

   5. Berkus Method – this method not advisable for Indian startups as the value allocated to each factor is arbitrary in the Indian context

   6. Cost to Duplicate Approach – this method is more relevant for liquidation event as it does not consider the startup’s future potential or value of intangibles

      
      

2. Which methodology suits best for your startup depending on stage?

   1. Pre-revenue and Early Revenue (up to Rs. 1 Crore annual revenue): Combination of Bill Payne’s method, DCF and CTM

   2. Early, Growth and Late Stage: Combination of DCF, CTM and VCM

      
      

3. What tweaks are required to be made in each method when valuing startups vis-à-vis a mature business?

   1. Discounted Cash Flow Method – The discount rate used for discounting the future cash flows should appropriately factor in the risks involved in startup investments. We consider the Weighted Average Cost of Capital (WACC) of the startup for the discount rate. For computation of WACC, computation of cost of equity involves a critical tweak, to factor in the risks involved in startups investments:

      1. Compute the cost of equity (Ke) using the classic Capital Asset Pricing Model (CAPM), as one would compute for a usual company in the same sector

      2. For calculating the beta used in CAPM, preference is given to technology companies and companies who have recently been listed on the stock exchange, in the same sector as your startup, with the same revenue model and similar margin profile.

      3. Since the Company is in its initial phases of operations, the entity specific risks are high and therefore, the risk of investment is high. Moreover, the shares of the Company will not be freely transferable by the investor, therefore liquidity risk is also high. Therefore, an overall risk premium is added to the calculated Ke to reflect the degree of business and liquidity risk. The best part is, a high discount rate automatically factors in the risk of failure of early-stage ventures.

         
         

   2. Comparable Transaction Multiple Method – Following are the key considerations and tweaks for valuing startups:

      1. Firstly, and most importantly, when valuing startups that are raising capital by diluting minority stakes (i.e. less than 50%), which is the case in most fundraises, comparisons should never be made with multiples prevalent in M&A transactions, or transactions undertaken by large enterprises. This is because multiples in those transactions have different dynamics which will most likely either overvalue (M&A transactions have control premium) or undervalue (large enterprises have mature multiples) your startup.

      2. When preparing the list of comparable companies, preference should be given to Indian startups in the same sector and same solution as your startup. If this is not enough, Indian startups belonging to the same sector, different solution but having a similar revenue model shall be considered. For example, if your startup provides a fully integrated healthtech platform on SaaS model to Hospitals, healthtech startups providing other kinds of platforms to hospitals for another use case on SaaS model can be considered in the comps (“competition”) list. This is because the CTM method takes the EV/R or EV/EBITDA multiple of these comparable companies as the basis for valuation, and therefore similar companies having same revenue model will likely factor in the same economics as your startup, irrespective of the specific use case being targeted.

         If you still cannot find enough comparable companies, then you can consider other startups who have the same revenue model but belong to other sectors. For example, a defence tech company that sells manufactured products can be compared with a spacetech company that also sells manufactured products. A SaaS model should not be compared with a marketplace model or a product-based business, as it would completely disregard the economics of the business.

      3. At least 5 comparable companies shall be considered. 10 is the ideal number. Theoretically, even a single comparable company is enough, however, it will be a hard sell to investors.

      4. Preference should be given to transactions which have occurred more recently as it is more likely to represent the existing dynamics of venture ecosystem. For example, we refrain from using multiples garnered by startups in 2020 and 2021, because during these years valuations went off the roof owing to the influx of foreign capital into India, post which it came down drastically due to the onset of the funding winter.

      5. EV/R multiple shall be considered for early and growth stage ventures, because in these stages comparable companies do not usually have a positive EBITDA. EV/EBITDA multiple shall be considered for late stage fundraise.

      6. Startups in early stages usually grow at a very fast pace. It is not very strange to find 10x YoY growth in early years, or even more. Therefore, what is otherwise quite commonly used while valuing mature companies, maybe redundant for startup valuation – which is, the EV/R multiple being computed based on the historical revenue or last financial year’s revenue of the startup. Therefore, when computing EV/R, revenue of the next financial year, or the financial year in which the comparable transaction took place shall be considered. This makes sense also because it considers the investor’s perspective of investing on the basis of the startup’s future potential and not based on its historical performance.

         For example, take 2 different companies who raised funds during FY23-24 – Company A has a revenue of INR 10 Crores in FY22-23, and INR 12 Crores in FY23-24. Whereas Company B has a revenue of INR 10 Crores in FY22-23 and INR 20 Crores in FY23-24. Now, if we were to value both companies based on their historical revenue i.e. revenue in FY22-23 using an EV/R multiple, their valuation would be the same, because both have INR 10 Crores revenue in FY22-23. However, if we were to value them based on their next financial year’s revenue then Company B will garner a higher valuation as it posted a much higher growth. This is true in reality too, because when investors invest, they consider the current Annual Recurring Revenue (ARR) and growth trends in the past few weeks or months before they decide to invest.

         
         

   3. Venture Capital Method – Following are the key considerations and tweaks for valuing startups:

      1. The expected return on investment of the investor (“IRR”) shall be attuned to the stage of fundraise and the overall risk of failure of the startup.

      2. Another crucial consideration is the possible dilution in the investor’s stakes over the period of projections, without which the valuation will tend to be higher. Take this for example:

         Round size – INR 10 Crores, 5 Year IRR – 50%, 5th Year (Terminal Year) valuation using an industry multiple – INR 300 Crores. Therefore, value of investor’s investment after 5 years based on the IRR will be INR 76 Crores, which is about 25% of the company’s 5th year valuation. Now if no dilution is assumed in the investor’s stake over the 5-year period, the valuation of the company would be simply 10/25% i.e. INR 40 Crores. However, practically, the startup will raise multiple more rounds to get to a valuation of INR 300 Crores. Even a 20% stake dilution would mean the investor starts with 31.25% stakes in the company, which gives a much lower yet realistic valuation of INR 32 Crores.

         Startups usually raise multiple rounds in a span of 5-7 years, diluting 20-70% of founders’ and early investors’ stakes in the company. We usually rely on our proprietary research on India’s startup ecosystem for these variables.

Finally, there is something that we always tell founders when we help them with valuations – No matter how intricately you work out your valuations, in all probability the value at which investments are finally made will differ from the values worked out by you. And this is because of multiple factors such as the motivation and negotiation skills of the parties, the financing structure, transition of control or other factors unique to the transaction. Ultimately, the final valuation is the output of the negotiation between you and your investor. The range of valuation that you work out acts as an excellent reference point at the deal table. In the process, you set your own limits that guides you throughout the negotiation - how much you’re willing to compromise and at what point you should walk away.

PS. If all of this sounds daunting, you can reach out to us to help make things simpler for you.

PS. This content has been generated using HI (Human Intelligence).

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How can Chunder Khator help startups in conducting valuations?

• We help startups carry out an in-depth valuation of their venture, at the time of fundraising, or at the time of issue of ESOPs, or for statutory compliance. We usually use a combination of valuation methodologies like Discounted Cash Flow method, Venture Capital method, Comparative Company Analysis method, First Chicago method, Scorecard method, etc.

• For fundraising, it is more important to have a range of valuation to work with rather than have a single value, as fundraising is a negotiation process in which multiple factors are considered. We usually recommend using 2-3 methods to arrive at a range of valuation and stake dilution that the founders can refer to at the time of deal negotiation.

• We use premium databases and proprietary process to carry the valuation exercise that is readily accepted by founders and investors.

• We also issue valuation certificates which is required under various statutes viz. Income Tax Act, Companies Act and FEMA, by Registered Valuers, Merchant Bankers or Chartered Accountants.

• We have carried out business valuation of several startups in the past. We have also assisted several investors (angels and VCs) to validate the valuation of startups at the time of deal evaluation.

To carry out valuation of your startup, reach out to us here.

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What are the other areas where Chunder Khator can help startups and startup investors?

We help startups to build dynamic financial models (business projections) for planning and fundraising, draft/vet SHA and Term Sheet, draft and implement ESOP policy, provide advisory in relation to equity/debt fundraise, prepare MIS for investors, provide shared CFO services, provide tax advisory, and more.

We help startup investors to carry out in-depth market/finance/legal due diligence of startups, validate valuations and financial models, draft/vet SHA and Term Sheet, and also monitor investments post deal.

Know more about our startup services here.