Startup Valuation - Why and How

Startups have been the talk of the town for quite some time now and India in particular has been one of the focal points of global start up success story. Startups have become the driver of creativity and enterprise in the country with the government at both the Centre and the various states making Startups the centerpiece of industrial development. Amidst such fanfare one may wonder what may be considered a successful Startup. While there are a number of viewpoints to gauge the relative success of various Startups one of the more dominant view is that the success of a Startup lies in its valuation, or to put it in a different way, a successful Startup is one that secures a upper end valuation thereby proving its worth. But measurement of success is not the only consideration when Startups seek valuation, there are several other reasons as well, the most important being the obvious one – to raise funds for operations.


Why do Startups seek valuation?

  • For seeking Investment – Conducting Valuation of the Startup is important for Startups seeking funding in various stages of operation. The valuation report provides the investors, whether angel investors or venture capitalists, the assurance that their investment is justified, as valuation not only considers the present financial condition of the Startup but also their future performance. The valuation report provides a yardstick against which the investors decide how much they should invest in the Startup or whether Startup will be able to give expected returns on their investment. Apart from this, Valuation may be mandated by a Statute, which discussed as under:

  • Companies Act As per the Companies Act 2013, a Startup has to obtain Valuation Report from a Registered Valuer before issuing of shares under private placement or on Preferential basis. Startups also need a valuation report while issuing shares for consideration other than cash, issue of Sweat equity shares etc. However, no such valuation report is necessary when right issue is made by the Startup. The valuer should be registered with IBBI (Insolvency and Bankruptcy Board of India) as well as possess a certificate of practice from a Registered Valuation Organization.

  • Income Tax Act – As per sec 56(2) of the Income Tax Act (1961) states that where consideration received for issue of shares by certain companies exceeds the Fair Market Value, such excess shall be taxable. However, a Startup will be exempted provided they are registered with DPIIT and the difference between consideration and fair market valuation does not exceed Rs. Twenty-Five Crores. The valuation method used for the purpose of determining fair market value of shares may be either intrinsic value/ Net Asset Value (NAV) as determined by a Chartered Accountant or Merchant Banker of the company, or a valuation report made by a Merchant Banker based on Discounted Cash Flow method.

  • FEMA – Regulation 11 of the Foreign Exchange Management Rules (2020) stipulates that startup should submit valuation report for issuing shares to non-resident. Such valuation report should be prepared by a practicing Chartered Accountant or a Merchant Banker or Cost Accountant. Startups should ensure that such report is based on internationally accepted methodology including DCF and NAV methods. The valuation report will be filed by the startup with the RBI at the time of issue/transfer. FEMA mandates that the issue price of shares should be greater than its Fair Market Value of such shares in case the startup issues shares to a non-resident.

So far, we have established as to why Startups need to get their businesses valued. Now, let us understand the various methods of valuation that are usually adopted to value Startups.

So far, we have established as to why Startups need to get their businesses valued. Now, let us understand the various methods of valuation that are usually adopted to value Startups.


How to Value Startups? - Startup valuation methods

1. Berkus Approach

American venture capitalist and angel investor Dave Berkus have introduced The Berkus Approach of Startup valuation in which the valuation of the Startup enterprise is carried out based on a detailed assessment of what he identified as the five key success factors: (1) Basic value i.e. whether the Startup has a sound product idea, (2) Technology or whether a working prototype has been developed by the Startup, (3) Execution or whether the management team of the Startup have prior experience of navigating complex business environment, (4) Strategic relationships in core market of the Startup, and (5) Production and consequent sales i.e. whether the Startup has adequate production and distribution channels in place.

The valuation of the Startup involves adding up of the quantitative value of the five key success factors, the evaluation for which, is made by a detailed assessment of the Startup itself. Based on these numbers, the valuation of the Startup is arrived at. The Berkus Approach for Startup valuation is also sometimes referred to as ‘the Stage Development Method’ or the ‘Development Stage Valuation Approach’.

2. Scorecard Valuation Method

The Scorecard Valuation Method of Startup valuation first determines the average pre-money valuation of Startup businesses in a similar stage of its operation based in the same area, and then employs a scorecard system by comparing the Startup that needs valuing against, them in order to get an accurate valuation.

The first step involves the determination of the average pre-money valuation of pre-revenue Startups in the region and business sector of the target Startup which is then followed by using the Scorecard Method to compare and determine the pre-money valuation of pre-revenue Startup. An example of a Scorecard is given hereunder:

  • Strength of the Management Team of the Startup – 0-30% (weightage)

  • Size of the Opportunity – 0-25%

  • Product/Technology offered by the Startup – 0-15%

  • Competitive Environment in which the Startup operates – 0-10%

  • Marketing/Sales Channels/Partnerships – 0-10%

  • Need For Additional Investment – 0-5%

  • Other factors relevant to the Startup – 0-5%

Finally, the valuation of the Startup is arrived at by assigning a factor to each of the above qualities based on the target Startup and then to multiply the sum of factors by the average pre-money valuation of pre-revenue companies.


3. Cost to Duplicate Approach

The cost to duplicate approach, as it sounds, considers the value of the Startup to be equal to the total cost that an investor would require to duplicate the target Startup’s business. Therefore, all the relevant cost including product development cost and labour cost for programmer etc. incurred by the Startup are added to arrive at the valuation of the Startup. One of the major drawbacks of this approach of Startup valuation is that it does not take into account the future revenue estimate of the Startup and its intangible assets to arrive at the valuation. As a result, the Cost to Duplicate method of valuation can only be used as a lowball estimate of a Startup’s value.


4. Future Valuation Multiple Approach

The Future Valuation Multiple Approach primarily focuses on estimating the return on investment that the investors can expect in the near future from the Startup in question in the next five to ten years. Several projections of various performance parameters of the Startup are carried out for this purpose, including sales projections, growth projections, cost, other expenditure projections, etc., and the valuation of the Startup is arrived at based on such future projections.


5. Market Multiple Approach

The Market Multiple Approach of Startup valuation is one of the most popular Startup valuation methods. The market multiple method employs a suitable multiple to determine the valuation of the target Startup like most multiples do. Recent acquisitions on the market of an enterprise which is of similar nature to the Startup in question are taken into consideration, and a base multiple is determined based on the value of such acquisitions. The valuation of Startup is then arrived at by using this base market multiple.


6. Risk Factor Summation Approach

The Risk Factor Summation Approach arrives at the Startup valuation by taking into quantitative consideration various risks that are generally associated with the Startup business and have an effect on the return on investment provided by the Startup. Under the risk factor summation method of valuation, an estimated initial value is first calculated for the Startup by employing any of the other methods mentioned above. Different types of business risks are taken into account which the Startup is likely to experience in the business environment in which it functions. The effect of such risks whether positive or negative are factored into the initial value of the Startup, and an estimated valuation is arrived based on the effect of such associated risk.

All the risk factors are then summed up and such factor is multiplied with the initial value following the final valuation of the Startup is determined. Some of business risks associated with Startups that are normally taken into account while performing such valuation are management risk, political risk, manufacturing risk, market competition risk, investment and capital accumulation risk, technological risk, and legal environment risk.


7. Discounted Cash Flow Approach

The Discounted Cash Flow (DCF) Method of Startup valuation is one of the most popular method of valuations. It is also mandated in the Income Tax Act as the valuation method to be used while determining the fair market value of shares issued by the Startup either through private placement or preferential issue. The Discounted Cash flow method (DCF) considers the future cashflow generated by the Startup as the basis on which the valuation will be arrived at. For determining the future cash flow, the revenue and cost estimates of the Startup needs to be forecasted. Such forecast involves both data provided by the Startup and the valuer’s discretion and understanding of the environment in which the Startup operates. Once such forecast is made, the unlevered cash flow of the Startup is then determined by excluding non-cash items from the EBITDA. Generally, such forecast is made for 5-10 years from the date of valuation as the Startup is considered to become a mature business during such period and forecast beyond such period is difficult to make. As a result, a terminal value is used which is the present value of all the future cash flow of the Startup beyond the forecast period.

The next stage involves determining a suitable Discounting Rate relevant to the Startup which will be used to arrive at the Present Value (PV) of the future cash flow generated by Startup. Normally, the weighted average cost of capital (Kc) is used as the Discounting rate. Since the valuation pertains to an unlevered Startup Kd or cost of debt is taken as nil and therefore the Kc becomes equal to cost of equity (Ke ) which is the rate of return that the equity investors of the Startup expect. While there are various method for determining Ke, the most common method is the Capital Asset Pricing Method (CAPM) which adds a market risk premium relevant to the Startup to the risk free rate of return prevalent in the market.

Once the Discounting Rate has been determined for the Startup concerned, the forecasted cash flows and the terminal value is then discounted by such rate to arrive at the Enterprise Value (EV) for the Startup. Then actual cash flow and existing debt (if any) of the Startup is adjusted with the EV to arrive at the Equity Value which is the value of Startup to its equity investors.


8. First Chicago Method

The First Chicago Method of valuing Startups is particularly useful when the concerned Startup operated in a dynamic business environment and thereby it is prudent to arrive at valuations pertaining to various scenarios. This is the core principle of the First Chicago Method which whereby 3 distinct scenarios namely Best Case, Base Case and Worst-Case scenarios are considered while determining the Startup’s value. The various cases are assigned certain probabilities of occurrence and estimated revenue and expenses in each case is forecasted. The valuation is then arrived at by using methods like DCF or Venture Capital Method for each scenario and using the weighted average of the 3 valuations. Thereby prospective investors is provided with a holistic view of the Startup’s potential and its value.


9. Venture Capital Method

The Venture Capital Method (VC Method) is a useful method which is used for determining the pre-money valuation of pre-revenue Startups. The method was first conceptualized by Professor Bill Sahlman at Harvard Business School in 1987.

It is calculated as follows - Return on Investment (ROI) is calculated as Terminal (or Harvest) Value divided by Post-money Valuation or conversely, Post-money Valuation is Terminal Value divided by Anticipated ROI of the Startup. Finally, the Pre Money-Valuation of the Startup is arrived at by adjusting initial cash requirement from its Post Money Valuation.

Terminal (or Harvest) value is the Startup's expected selling price in the future, which is estimated by using reasonable expectation for revenues in the year of sale and estimated earnings.

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