Start-ups are a topic of interest and fascination to each and every person in the finance field, whether it is related to its business model or to its valuation. In this article we will put some light on the valuation part and if you are interested in making a business model for it you can visit our website for more information.

Value is not merely a number; math is just a part of it. It is much more than math, it depends on negotiations, future predictions of growth, goodwill of the product/ service, type of investor, etc. At an early stage, valuation is a function of cash burn with different scenarios of bootstrap and adequate funding, the stake that the promoter is willing to give up, value addition expected from potential investors and expected funds in future rounds with respective dilutions.

We have already stated how the value of a company also depends on the type of investor. Investors can vary based on the amount of investment required by the company. Either you can take a loan from the bank or investors by offering the company’s shares. Banks usually don’t lend money to companies having no short-term revenue generation capacity thus in that case you have to resort to other means such as angel funds, friends & family, venture capital, etc. Different types of investors have different types of investing capacities which can be categorised as follows:

• Pre-seed: Less than 50 lacs for validating the hypothesis of business, this is mainly invested by the promoter himself from his savings, friends and family or grants.

• Seed: Between 50 lacs to 5 crores for figuring out product/ service and getting it to fit users demand, this is mainly invested by friends and family, angel funds, business angels (NHIs) or venture capitalists.

• Series A & B: Between 5 crores to 50 crores for scaling the product and getting it to fit market demands, this is mainly invested by private equity funds, venture capitalists, wealth managers or corporate funds.

• Series C+: Between 5 crores to 50 crores for accelerating what it is doing, going international and for acquisitions, it is mainly invested by private equity funds, growth funds, hedge funds or sovereign wealth funds.

• Beyond that: Above 50 crores companies mainly go for mergers or acquisitions or initial public offerings.

The current valuation landscape is divided into two categories of people – Narrative and Number people. Narrative people believe in sound stories and that a value can’t be achieved if there is uncertainty in assumptions. Number people believe that valuation is only about numbers and narratives are a distraction that brings irrationalities into investing. Value is a number achieved by combining stories and numbers. We can achieve value by having rational narratives i.e. assumptions and predictions made by the management for their products/ services which is also backed by numbers. Stories tell the vision, the potential and convert it into numbers whereas numbers have realistic assumptions backed by market data and by combining the two we can have a more reliable value.

Now that we have discussed the type of investors lets move onto the business part and see how to value the same.
Every business has its life cycle which can be broadly divided into five phases- 

• Start-up idea, 
• Rapid expansion, 
• High growth, 
• Mature growth and 
• Decline phase

Each phase has its challenges and advantages which affect the valuation of the business. For valuing a company in an initial stage, it mostly depends on the future expectations of management of revenues as it is not earning enough and can have negative profits in that stage too. It might be difficult for a valuer to analyse its operations; valuer will have difficulty in using the market approach and thus the source of value is purely based on the future prospects of the business.

The valuation equation is as follows:
Pre-money valuation + Investment = Post-money valuation
(Pre-money valuation is value of the company before infusion of funds in the company
Post-money valuation is value of the company after infusion of funds in the company)

There are various methods and principles to value a start-up company which are explained briefly in the following paragraphs:

• Discounted cashflows method: This method values the company on the basis of estimated future cashflows generating capacity of the company. The future cashflows are discounted to the present values using appropriate rates such as weighted average cost of capital (‘WACC’). For start-ups, this method may have some difficulty in valuing the company as it is highly dependent on the assumptions made by the management.

• Comparable companies’ method: In this method, various average multiples of companies which are similar to the company and are publicly traded is used based on EBITDA, EBIT, revenue, gross margins, HR headcounts, number of outlets, etc. to value the company. It also has its own limitations for instance it is difficult to find publicly traded companies which can be proxy to the start-up, due to low revenue or negative margins EBITDA/ PE multiples are futile, etc.

• Net asset value method: It is also known as book value method because it measures the value of the company based on the net assets of the company. It doesn’t account for intangible assets for instance brand, patent, database, etc. For start-ups, their intangibles are of great value as their future business is dependent on today’s intangibles such as research and development for biotech companies, software for web start-ups, etc. Also, start-ups mostly don’t purchase fixed assets rather take them on lease. Thus, this method doesn’t have great significance in valuing start-ups.

• Berkus method: This method is broadly based on its five parameters and probability of those parameters. It is meant for pre-revenue start-ups. It is also based on an idea where 1 in 1,000 companies will achieve its projected revenue thus management’s projections don’t hold much significance. The pre-money valuation of the company can be USD 2.5 million maximum based on its five factors where each factor can have its value up to USD 0.5 million only. The five factors that are being talked about in this paragraph are as follows – Sound idea, prototype, quality management team, strategic relationship and product rollout or sales. These factors are awarded with certain probability for finding out the value of the company.

• Scorecard method: This method is based on the quality of start-ups today instead of future cashflow generating capacity of the company. In this method the value of the company is arrived by following three steps.
  Step 1- In this step, average pre-money value of the comparable companies is calculated.
  Step 2 – In this step, 7 critical metrics are assigned weights and a start-up score in the range from 0.5 to 1.5 to arrive at a weighted average rate.
  Step 3 – In this step, pre-money valuation of the company is arrived by multiplying weighted average rate calculated in step 2 with average pre-money valuation calculated in step 1.
  
  
• Risk factor summation method: This method is based on the riskiness of the company. It is used for arriving at the pre-money value of the company by comparing its riskiness with other start-ups. This method has steps similar to the Scorecard method which are as follows:
  Step 1: Calculate average pre-money valuation of comparable companies in the same way as calculated in the above method
  Step 2: Evaluate 12 factors and assign them rating in the range from -2 to +2 according to the risk associated with each factor (1 rating = USD 0.25 million) and add the values of all 12 factors
  Step 3: Adjust the pre-money value in step 1 with the value arrived in step 2

• Venture capital method: To arrive at the value of business this method considers both –multiples-based valuation and a discounted cashflow valuation approach. It measures both pre-money and post-money values. This method is based on the viewpoint of the investors such as the expected return on investment and anticipated exit value of the business.
  
  
• First Chicago method: This method is based on Venture capital method, developed by the venture capital arm of First Chicago for post-revenue start-ups. This method uses value of business in three scenarios – best case, base case and worst case, and to these cases probability of that outcome is applied to arrive at pre-money valuation. In all the three scenarios values are calculated using either venture capital method or discounted cashflow method.

Some key factors for start-up valuation:

• Terminal value
  Terminal value is a big chunk of start up value. It is calculated assuming that the company is a going concern and is a function of perpetual growth rate. Terminal value is a value of cashflows beyond the forecasted horizon period. This value can be calculated using perpetual growth (Gordon’s Growth model) or exit multiple or value if company goes into liquidation after the forecasted period.
• Key person discount
  Value of the business can vary if one or more key people leave the business and thus, we apply a discount on the value of the business. One main person leaving a company may deplete the value of the company hence the buyer will want to pay a value less than that arrived at by applying a key person discount.
  Key person discount = (value of company with status quo − value of company when key person is lost)/ value of company with status quo.

To conclude this article, we can say that there is no specific way to value a start-up as it is dependent on the management’s vision and valuer’s assumption. We have tried our best to take you on a small ride of valuing start-ups from explaining the types of investors to the methods of valuing a start-up.