#TaxmannPPT | Valuation of Start-ups with Case Studies

WhatsApp Story

What led to WhatsApp valuation of USD 17 billion?

Year 2013

Active Users: 450 million

Revenue: USD 10 mn

Loss: USD 138 mn

Valuation : USD 1.8 bn

Goodwill: USD 17.2 bn

What’s a Start-up

Innovation

Creativity Startup

Risk Taking

What’s a Start-up

An entity shall be considered as a Startup:

• Up to 10 years from incorporation

• Private company or Partnership or LLP

• Turnover less than INR 100 crore (in any year)

• Working towards innovation, development or improvement of products or processes or services, or

• a scalable business model with a high potential of employment generation or wealth creation.

Ministry of commerce and industry (Department of Industrial Policy and Promotion)

SEBI has adopted the same definition under AIF regulations

Income Tax Department is using the same definition for tax breaks

That’s only legal definition for getting tax breaks.

Anycompanythat’sconstantlyinnovating/pivotingis practicallyastart-up

…notjustanynewcompanythat’sdoingsomethingdifferent

What’s typical about startups while valuation?

Stageinlifecycle:youngandlessmature,feweremployees, lowerassets,minimalcapital

Size:Smallersize;higherlevelsofrisk;limitedaccesstocapital markets

[callsforasmallsizediscount(premiumwhilecalculatingdiscount rate)whencomparedwithpubliccompanies]

Overlapinshareholderandmanagement:Shareholders arethemanagement;lessagencyproblem

Qualityoffinancialinformation:lackofreliabledata;lower history;discretionaryspends;questionablefinancialreporting;focuson reducingtaxes;

Let’s understand the life cycle stage of the company

Earlystage:

Acompanyintheearlieststagesofdevelopmentshouldbevaluedusingthe asset-basedapproachasfuturecashflowsmightbetoounpredictableandthereis noguaranteethatthecompanywillbeabletooperateasagoingconcernforthe foreseeablefuture.

Haveestablishedproduct-marketfit(PMF)

Acompanythathassuccessfullynegotiatedtheearlydevelopmentstageandis witnessinghighgrowthshouldbevaluedusingtheincomeapproach.

Maturedstartups

Astable,relativelymaturecompanyshouldbevaluedusingthemarketapproachor

Incomeapproach

Why do most startups fail?

Poor corporate governance

Underestimating competition

Not adaptable to market needs

Lack of Persistence

Quitting too early

Running out of money or resources

Too slow on pick up, Late execution

Fear of taking risks

Get a Story and estimate the climax

Everyvaluationisbasedonastory.Don’tfallforVFXs Don’thidebehindmanagementforecasts.Youstillownthevalueyoureport.

May not survive in long run

Applyprobabilityof default

Future of the company

Will survive and scale despite competition

Will scale on its own

Applyperpetualcash flowsinTV

Will get acquired by competition

ApplyExitmultiplein TV

Developing company life cycle

Expense History Limited Substantive Substantive Substantive Established history Established history

Profitability Loss Loss Loss Loss Breakeven / profitable Established history

Financing Sources Angels / Early VC VC VC / Strategic Mez fin / strategics Strategics / IPO Self Funding / Debt + Equity

Valuation methods across stages of startups

Focus on Market

Competition

Barriers to entry

Sustainable differentiation

TAM

Crowded space = market erosion

Size & growth

Macro trends and timing

Measure of consumer intent

Focus on

Product Scalability, Competitiveness

Business Model

Recurring revenue, shorter sales cycle, large value proposition

Traction

Financials

Growth, Customer engagement, customer retention

Burn and use of funds, positive contribution, previous rounds, past valuation, dilution

New, Experienced, Potential, Tech, Co-founders

Team

How early stage companies get their valuations

Story

Negotiation

Most investors bet on the founders and their business story. No one knows the future and thus, valuation is often difficult and always wrong

During early stages, funds are raised based on negotiation [the early stage version of demand and supply] and thus, startups are “priced” not “valued”.

Assigning premiums in valuation

Is it solving any major problem?

No

Is there huge scaling opportunity?

No major Premium Valuation

- Cost Approach

- Income Approach (High Probability of default)

Major Valuation Premium

- Using Benchmark multiples (value available)

- Lower Discount Rate (with lower probability of default)

Yes

Are there existing player?

Can it sustain the cash flows and high margins?

Venture Capital Method of Valuation

Step 1: Estimate the expected earnings or revenues in a future year.

Step 2: Multiply the earnings in the future year by the multiples of earnings.

Step 3: The estimated value is discounted back at the target rate of return.

Valuation methods

• Market Approach

• Multiples

• Industry valuation benchmarks - useful as a sanity check of values

• Available market prices

• Income Approach

• Discounted Cash Flow Method

• Replacement Cost Approach

• Net Assets

VC Return Expectations

• The rates of return expected by Venture Capitalists for companies in different stages of financing as described in the two publications identified in the American Institute of Certified Public Accountants (AICPA)

1.Plummer,JamesL.,QEDReportonVentureCapitalFinancialAnalysis

2.Scherlis,DanielR.andWilliamA.Sahlman,“AMethodforValuingHigh,Risk,LongTerm,Investments:TheVentureCapitalMethod,”Harvard BusinessSchool

Venture Capital Method of Valuation

Example:

A young EdTech company Om Ltd is expected to go public in 10 years from now. The valuer expects that the net profits of the company 10 years from now will be INR 95 crores.

Average PE Multiple of publicly traded EdTech companies is 20. Om Ltd is evaluating fund raising from investors. Investors are expecting 45 percent from the investment until the company goes public.

Solution:

Exit Value = 95 x 20 = INR 1900 Crore

Value of the company today = 1900 / 1.45^10 = INR 46.25 Cr

Other Methods of Valuation

BerkusMethod

Key success factors

Sound Idea (basic value)

Prototype (reducing technology risk)

Quality Management team (reducing execution risk)

Strategic Relationships (reducing market risk)

Product Rollout

Add to company value up to:

USD ½ million

USD ½ million

USD ½ million

USD ½ million

USD ½ million

Other Methods of Valuation

FirstChicagoMethod

• Projectingfuturecashflows:

• ProjectingTerminalValue:

• Discounting back future cash flows and terminal value:

• Calculatingpresentvalueofthefirm:

Valuing using Operating Value Drivers

Valuing Flipkart

Amazon = Market Capitalisation

Number of Users on Amazon.

Value Driver: Value per user (ValuePU) = Market Cap / No. of users.

Flipkart Value = Number of users (given by Flipkart) x ValuePU

Adjustment for:

• Marketability [Listed vs Unlisted]

• Country specific growth factors – US Growth vs India growth

• Global presence

• Product diversification

• Currency differences

Alternatively, Ecommerce companies were valued based GMV Multiple.

Example – Valuing Pre-Revenue Company

Numbers

Example - Valuation using transaction multiples

Case - ZOMATO

Case - ZOMATO

Case – ZOMATO Value Drivers

Key Business and Revenue Model

Food Delivery (Transaction based advertising)

Revenue Drivers and Cost drivers

Dining (Advertising)

Hyperpure (Transaction based)

Zomato pro (Subscription)

Key performance indicators No.

No. of Monthly transacting users

Order frequency

Commission Rates restaurant partners

Delivery Ads from Restaurant partners

Key Costs: Delivery Cost, Discounts and marketing spends

No. of Monthly Average Users

Delivery Ads from Restaurant partners

Key Costs: Sales team

No. of Restaurant partners

Order Frequency

Value of supplies per order

Key Costs: Cost of goods sold

Membership Fees

No. of pro members

Key Costs: Marketing