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SEBI’s recent grown interest in Start-up Valuations

SEBI seeks details on Start-ups Valuation from PE, VC Funds 

As per the recent communication by the capital market regulator, Securities and exchange board of India (SEBI), is seeking transparency in valuation of start-ups by asking private equity (PE) and venture capital (VC) funds to share details of valuers employed and practices followed. The regulatory intent here is to lower risks faced by investors by raising the bar on disclosure for close-ended alternative investment funds (AIF), which is typically the route VC takes to fund start-up. As private pools of capital grow in size, Sebi’s approach to regulation is pivoting from minimising the systemic risk to a scrutiny of the business risk. As of now, SEBI is yet to make an official statement regarding this decision.

However, this will be interesting to see whether SEBI would agree with the approach used by the funds for the valuation of these start-ups considering that a wide variety of such approaches are in vogue. Popular forms of valuation exist with methodologies falling into broad categories of stage development, cost-to-duplicate, future valuation, market multiple, risk factor summation and discounted cash flow. Venture capitalists have their preferences, which can involve a combination of approaches.

Driven by complaints from investors and recent reports of opaque accounting of a few unicorns, the Securities & Exchange Board of India (Sebi), in a communication on September 6, asked a large number of funds to disclose their valuation practices and share details like the qualification of the valuer, whether the valuer hired is an associate of the fund or its manager or sponsor, and if there was a significant change in the valuation methodology in the past three years among other things.

Start-up Valuation - Factors on which valuation depends: -

Valuation of a Start-up can depend on several factors including, but not limited to:

  • Business stage – Angel/VC/PE/ Debt Funding
  • Nil/Minimal track record
  • Burning Cash
  • Nil/Minimal Fixed Assets
  • Quality of Management
  • Business model
  • Proof of Concept
  • Scalability
  • Technical & Commercial Feasibility

 

Methods of Valuing a Start-up 

Since there is little or no reliable data present, a valuer may at his discretion use the following methods to value a start-up. The first few methods are more conventional methods of valuing a start-up, the latter are more creative and qualitative in nature. 

Discounted Cash Flow Method 

This is the method which is widely used in valuations. The basic concept behind valuation using discounted cashflow method is to calculate how much cash the start-up is going to generate till perpetuity, summing up those cashflows and then discounting it back to the present value.

The income approach is widely used for valuation under "Going Concern" basis. It focuses on the income generated by the start-ups in the past as well as its future earning capability. DCF Method under the income approach seeks to arrive at a valuation based on the strength of future cash flows.

Under the DCF Method, the fund is valued by discounting its free cash flows for the explicit forecast period and the perpetuity value thereafter. The free cash flows represent the cash available for distribution to both, the owners and creditors of the business. The free cash flows in the explicit period and those in perpetuity are discounted by the Weighted Average Cost of Capital (WACC). The WACC based on an optimal vis-a-vis actual capital structure is an appropriate rate of discount to calculate the present value of the future cash flows as it considers equity-debt risk by incorporating the debt-equity ratio of the fund.

Most start-ups do not have comparable companies. Consequently, there is no way in which we can run a regression of past returns, get an equity beta, or use a market beta/interest rate on debt.

The perpetuity (terminal) value is calculated based on the business potential for further growth beyond the explicit forecast period. The "constant growth model" is applied, which implies an expected constant level of growth for perpetuity in the cash flows over the last year of the forecast period.

The discounting factor (rate of discounting the future cash flows) reflects not only the time value of money, but also the risk associated with the business’s future operations.

The Enterprise Value (aggregate of the present value of explicit period and terminal period cash flows) so derived, is further adjusted for:

  • Estimated value of Contingent Liabilities likely to get crystallized (management estimate)
  • Cash & Bank balances
  • Surplus assets like land not in use
  • Borrowings/loans and advances
  • Value of non-trade Investments, if any
  • Preference shareholder liability, if any

to arrive at the value to the owners of the business.

 

Practical difficulties for DCF with respect to Start-up Valuation 

  • Forecasting future cash flows is not easy (Due to absence of historical data)
  • Finding appropriate beta in Indian market conditions may not be a wholly objective exercise
  • Risk assumptions are tough to estimate since start-ups carry a significant portion of hidden risk.

 

How a valuer can overcome these difficulties? 

Since there’s no dependable actual revenue figures in case of a start-up, a valuer must synthesis these revenue figures and projections using assumptions that best matches the narrative of what the start-up business is about as well as make assumptions consistent with what the management of the start-up is planning to do. This will require a strong communication between the start-up and the valuer to mitigate any type of overstatement/understatement of the value of the start-up. 

This method is best to understand the subjectivity of the practice of valuation. In absence of historical data, this method allows the valuer to synthesis the assumptions on which the projections are dependent on, giving a higher degree of flexibility to the valuer to adjust for the problems faced in start-up valuation. Synthesising key assumptions in any type of financial model requires a ton of research which must be done in cases where there is no revenue that can be used to project future cashflows.

Some key points to consider when valuing a start-up using this method are given as follows:

  • What stage of business cycle is the start-up in.
  • Is there availability of any historical data.
  • What are the key revenue drivers.
  • What are the future plans of the firm (In terms of expansion as well as product/service roll out)
  • Technological relevance of the start-up in the future.
  • Risk considerations and premiums that should be applied (Subjective on a case to case basis).

 

First Chicago Method 

The First Chicago Method of valuation is one of the more complex and at the same time the more flexible of all the methods described above. This Method is widely used by PEs, VCs as well as AIFs to value Dynamic Growth Companies and Post-Revenue StartUps. 

In this method we do not compute for one single value of the start-up, rather, there is a requirement to create three possible valuations of the start-up:

 

  1. Best Case Scenario (Bull Case)- This case represents the best possible valuation.
  2. Normal Case Scenario (Base Case) –This case represents a regular valuation pertaining to normal market conditions.
  3. Worst Case Scenario (Bear Case) – This case represents the worst possible valuation.

(All of these valuations are to be made using the DCF method, But, if that is not possible, internal rate of return or Comparable Company Method can be used)

After computing these valuations, they must be weighed against the probability assumed by the valuer of any of the three scenarios to occur. To understand this in a better way, refer to the example below:

Scenarios

Valuation

Probability

Weighted Average Value

Case 1 (Best case Scenario)

$300 million

10%

$30 million

Case 2 (Base Case Scenario)

$70 million

70%

$49 million

Case 3 (Worst Case Scenario)

$10 million

20%

$2 million

Total (Value of the firm)

$81 million

 

Start-Up Valuation: Comparable Company Analysis 

This method of valuation is well known to valuers. It is also called the Market multiple method. In this method the valuation of the target start-up is derived from similar comparable companies that are traded openly in the market (Trading Multiple Approach) or by looking at how similar comparable companies are being bought and sold (Transaction Multiple Approach)

In case of start-ups this method is not so reliable because most start-ups lack similar comparable peers. There may be similar companies that the start-up may relate with but it’s very difficult to make an apple to-apple comparison in start-up valuation.

Even though there may not be realistic multiples available for a certain type of start-up, a valuer may use synthetic multiples to arrive at a valuation for a start-up using this method. 

 

Book Value Method 

Book Value Method of valuation is another very straightforward method of valuing a company that carries all of its focus on tangible assets. All estimations, growth, future revenue, branding etc. would not really matter in this valuation. The value of the start-up is determined by adding all the tangible assets of the firm. The only requirement for this valuation is the audited financial statements.

There are several drawbacks to this method, such as:

  • Book value of an asset can be easily overstated or understated.
  • Valuation becomes tough when valuation is done in between a financial year.

This approach revolves around the tangible assets and value of the firm, but start-ups focus mainly on deriving value from intangible assets rendering this method irrelevant.  

 

Liquidation Value Method 

Liquidation value method can be called as an extension to the book value method. Liquidation value of the firm refers to the value that measures what an investor may get out of the business and whereas the book value measures what an investor has put into a business.

This type of valuation is usually used in situations where there is an urgency of asset sale, usually in case of winding up of start-ups. The liquidation value of assets will usually be less than the book value since there is an urgency of sales.

 

Venture Capital Method 

Just like the name suggests, this method is majorly used by Venture Capital Funds to value start-ups. This method was first described by Professor Bill Sahlman at Harvard business school in 1987. This method of valuation can be used for Pre as well as post-Revenue Start-ups.

The value for a start-up is computed using the following formulas: 

 

To understand this method much more clearly, lets take an example:

If you were to value a company, in which the investor’s anticipated exit value (Terminal Value/Harvest value) is $100 Million, the target ROI is 20x and the amount to be invested is $1 million. To solve for Post-money valuation we will simply divide the two values. Now the next step involves is to compute the company at pre-money (Before Dilution). The last step to calculate the value of the firm is to adjust for dilution of equity. 

The calculations for the above-mentioned scenario is as follows: 

  

 

Start-Up Valuation: The Berkus Method 

This method was introduced by renounced author and angel investor Dave Berkus. According to him, projections for a start-up cannot be relied upon when one needs to value the business. There is a very low possibility to make accurate and reliable projections from almost no historical data.

Berkus method is a pretty straight forward and a simple method of valuation where there is little or no historical data is present. Usually, this method is used to value a start-up in pre-revenue phase. This method considers 5 key aspects of the start-up and puts a value to those 5 key aspects between $0-$500,000.

Under this approach, the valuation is to be made very conservatively because of the extreme riskiness of start-ups. This is to make sure that the investor has an actual opportunity to gain a significant appreciation in the initial investment as well as to safeguard the investor from a significant loss.

The 5 key aspects of a start-up that is evaluated in this method are as follows:

  • Sound Idea (Basic Value)
  • Prototype (Technology)
  • Quality Management Team (Execution)
  • Strategic relationships (Go to market strategy)
  • Product Roll out and sales

Once the Start-up is out of pre revenue phase and starts generating revenue for a period of time, this method of valuation becomes obsolete since now the projections can be made using actual revenue figures. 

 

Risk Factor Summation 

This method of valuation revolves around the number of risk factors involved for the start-up that is being valued. More the number of risk factors, higher the overall risk. This method forces the investor to be conservative and also to think about the number of risks that the venture needs to manage, so that a lucrative exit can be achieved.

This method can also be considered as a much more evolved version of the Berkus method. Just like Berkus method this method is also used to value start-ups in pre revenue stage. There are generally 12 risk-factor mentioned in this method, but a start-up may or may not include all 12 of them.

The value is estimated by looking at the following mentioned risk factors involved:

 

Risk Factors

Management risk

Stage Of Business

Legislative/political risk

Manufacturing risk

Sales and manufacturing risk

Funding/ Capital Raising risk

Competition risk

Technology risk

Litigation risk

International risk

Reputation risk

Potential lucrative exit

 

Score Card Method of Valuation 

Score card method is quite similar to the Risk Factor Summation method (RFS). In the RFS method we set a base valuation for a start-up and then factor in the criteria of valuation. In this method, the criteria involved in valuation are themselves weighted on the basis of the impact on the overall performance of the project. Based on the weighted average value of these criteria we then calculate the value of the start-up using its initial value.

Normally there are 4 criteria under this valuation:

  • Team capacity
  • Product/technology readiness
  • Market size
  • Competition

Another very popular variation of this method is the Bill Payne Method. In this method there are 6 criteria that a valuer should consider when valuing a start-up. They are as follow:

  • Strength of management team
  • Size of opportunities
  • Product and Technology
  • Competitive environment
  • Marketing and sales channel partnerships
  • Need for additional funding

These criteria are not binding, they can be adjusted with respect to the start-up that is being valued. There can be an inclusion of any numbers of criteria subject to the valuer’s understanding of the start-up business. 

Concluding Thoughts

A good valuation requires two things, a good narrative and consistent numbers complementing that narrative. If any one of these aspects are left out, the valuation done may not be as fruitful. Valuation is a science as well as an art which gives the valuer a good amount of space to play around with. It’s very simple to present an inflated valuation of a start-up, which is becoming a major concern for SEBI. The regulators directive is looked upon as a precursor to guidelines for valuation and enhanced disclosure, but it is not really possible to set a guideline on how to value these emerging start-ups. The subjectivity of the practice of valuation in any case would not allow such an event to occur.

To value new emerging start-ups, conventional methods of valuation may not produce the actual value of the firm. Valuers need to think outside the box to put a value to a Start-up. The requirement for a better understanding of the valuation methodologies paves way for a valuer to assess multiple ways by which the valuation can be derived for a start-up.   

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