Valuation Techniques: Early stage companies

Contributed by: Kartik Gupta

The IAIP Delhi chapter invited Varun Gupta, M.D American Appraisal to shed light on the valuation of early stage companies. With many CFA charterholders and aspiring candidates in attendance there was exuberance in the air. Before Varun began the presentation, Aviral Jain CFA, Chair, Investment Research Challange, IAIP showed us a small video of the upcoming IAIP India Investment conference, which will happen on 9th of January in Mumbai.

Varun started with discussing the new gold rush in silicon valley with technology startups having  found a new footing with the recent acquisition of Whatsapp for $19 Billion and the recent UBER valuation at $40 Billion. According to Forbes, over 30 startups including Zenefits-cloud based human resources app, Thumbtack-local e-commerce company and Thousand eyes-IT monitoring startup have seen their valuations skyrocket. In India, Flipkart has now been valued at $10 billion, Snapdeal is valued at nearly $2 Billion and Ola Cabs is valued at nearly $1 billion. These valuations pose more questions than answers for people not privy to their workings.

Early Stage Company

An early stage company is distinctly defined by either Non-existing or low revenues or negative operating income, Whatsapp has still not returned a profit in its years of existence, neither has Zomato or Flipkart. The operating history of the companies is fairly new and there are very few or no comparable companies that exist in the market. Their source of value stems entirely from future growth. These companies are highly dependent on external sources of funding, in the case of Flipkart we have seen several rounds of funding with the previous two rounds infusing a cash of $180 million and $1 Billion. These companies are cash guzzlers, with an objective to increase user base and topline growth. Early stage startups create products that are generally illiquid in nature, as the products have not yet or are near to achieving market acceptance.

The most importance feature is the shareholding structure of these companies, which are highly complex with multiple claims on equity. This creates the conundrum for the valuer-with multiple claims on equity that present themselves in the form of preferred shares that come with their own share of covenants and convertible features. The traditional formula for valuation does not give an accurate measure.

With almost zero to negative revenues and no direct comparable, valuation of startups moves towards the narrative in other words the potential for growth for these companies helps to define their valuation.

The three key points that are support the narrative become

  1. Equity Requirement
  2. Investor IRR requirement
  3. Expected Exit valuation

Varun’s presentation was insightful in understanding the difficulties experts deal with in early stage valuation of companies, and many a heated discussion took place among the various techniques used for valuation.

Valuation Methodologies for early stage companies

Method 1: Basic Venture Capitalist Approach

The basic VC formula identifies, the key points namely the investor IRR, which is the projected rate of return of the risk of the project; the equity requirement that the investee company requires for expansion and the expected exit expectations of the investor. This helps determine the stake that the VC must own to help achieve their goals.

Method 2: First Chicago Method

First Chicago approach simply does three different projections: Success, Failure and Survival cases and assigns probability estimates to each . This method results in a separate valuation and pricing for each of the three outcomes . These are then averaged and the weighted average valuation is determined (weights being the probability assigned to each case).

Method 3: Score Card method

The first step in using the Scorecard Method is to determine the average pre-money valuation of early stage companies in the region and business sector of the subject company.

In the next step, the VC compares the subject company to his perception of similar deals, considering factors such as

  • Strength of the Management Team;
  • Size of the Opportunity;
  • Product/ technology risk, among others.

The subjective rating of factors is typical for investor appraisal of startup ventures

Sample Score Card Table

Comparison factor Range Weights Company Rating Factor
Team/Management 0-40% 30% 1.25 0.375
Size of  Opportunity 0-30% 25% 1.5 0.375
Product/Technology 0-20% 15% 1 0.15
Competition 0-15% 10% 0.8 0.08
Sales partnerships 0-15% 10% 0.8 0.08
Additional investment 0-10% 5% 1 0.05
Other factors 0-10% 5% 1 0.05
Total   100%   1.08

Multiplying the Sum of Factors with the average pre-money valuation provides the pre-money valuation for the subject company. 

Alternative Approaches

There are many challenges in applying typical valuation approaches, we need to consider some modified approaches, these can be:

In-phase valuation

This approach for valuing business understands that for early stage cash flows the entire stream of cash flows should not be discounted in one step, but should be broken down into different phases  and each phase should be discounted separately, it also takes into account the changing risk and return expiration in each phase.

Real Option

While generally used for capital budgeting, this approach for valuing businesses adds flexibility into the traditional discounted cash flow approach, embedded real option helps identify value drivers for a business. The underlying asset in this approach is the present value of the project cash flows and the exercise price is the expected investment to be made, contingent to earlier phases.

Backsolve Method

The Backsolve Method derives the implied equity value for the company from a transaction involving the company’s own securities, typically, the preferred stock. It indicates an equity value that is consistent with the rate of return the investors in the most recent round expected given the degree of marketability of their investment as well as any special rights (e.g., liquidation preferences) accorded to them.

Option Pricing Model

The most common method to apply Backsolve is through the Option Pricing model. This model treats common and preferred stock as call options on the value of the business.  Common stock only has value if the funds available, at the time of a liquidity event (e.g., merger or sale), exceed the preferred liquidation value. In other words common shareholders have the option to buy the underlying asset (the company) at an exercise price equal to the liquidation preference amount.

Varun walked us through each valuation technique in detail, opening questions and stopping to explain more delicate points. He carries weight in his answers and comes from over 18 years’ experience in the field of valuation.

Varun also advises that no one valuation technique is error-free, every approach has its advantages and disadvantages, and while one single approach may not explain outright several approaches together may help identify a range for valuation.

Post Lunch He walked us through the workings of American Appraisal and its contribution to valuation and advisory services. The session ended on a high note leaving us with a lot to think about. We were armed now with techniques to help us search for answers on the elusive questions of valuation.

 – KG

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