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Startup ecosystem in India has been expanding at a very faster pace in India. Recently, many young companies have been categorized as Unicorns (companies having value over one billion dollar / INR 7500 Crore approx.). There are many confusions regarding valuing a startup such as technique to be used, valid information and data sources and acceptability etc. Many entrepreneurs, investors and professionals argue that startups cannot be valued because they have no historical data, track record and in some cases do not have valid product or services to offer.
We are of the opinion that irrespective of the stage of business, whether it’s a startup or a mature company, fundamentals and basis of valuation remains same for every business. Value of a startup business shall also be the present value of the expected cash flows from the operations. However, it is very difficult to value a startup using traditional methods due to reasons mentioned hereunder. In this article, we shall discuss about the practical aspect of valuation of startups and requirements.
Information and data for valuation
Information and data play a vital role in valuation of any business. Any discrepancy in information and data may lead to misevaluation which may lead to losses to the investors and the businesses as well. Therefore, correctness, completeness and validity of information and data is very crucial. Following are the source of Information for valuing a business:
The first is the current financial statements of the business. These statements can be used to determine profitability of the business, how much the business reinvests back to generate future growth and other information and inputs that are required in any valuation.
The second is the past history of the business, in terms of earnings and market prices. Earnings and revenue history of the business helps in assessing the business cycle and growth of the business over the period of time, and price history can help in measuring the risk of business.
Lastly, one can look at the competitors or peer group of the business to compare it. It helps in measuring how much better or worse a business is than its competition, and also in estimating key inputs on risk, growth, and cash flows.
In case of startups, you may be constrained by the unavailability of adequate information. Information is unavailable due to the following reasons:
- Startups usually have been in existence for not more than a year or two, leading to a very limited history and track record.
- Their current financial statements exhibits very little about the component of their assets expected growth-that contributes the most to their value.
- These businesses are generally innovative and often represent the first of their kind of business. In most of the cases, there are no competitors or a peer group against which they can be compared and measured.
Investors’ Approach and Valuation Models
Startup investors have responded to the absence of information in many ways. Some have decided that these businesses cannot be valued and should not therefore be held in a portfolio. Others have argued that while valuation of these businesses cannot be done with traditional/conventional valuation models, the fault lies in the models. They have developed some new and inventive ways of valuing startups which are based on the limited information available in order to justify the prices paid for these businesses.
Valuation methodologies can be developed considering various factors and limitations; however, sanctity and performance of these models should be tested before relying and making decisions.
Valuing a Startup
The basics of valuation are very clear. Value of a business is based on its capacity to generate cash flows and the uncertainty associated with these cash flows. In other words, more profitable business shall be valued higher than less profitable business.
However, this principle shall not apply to startups as most of the startups are loss making and lack information. Despite of this fact, they are highly valued. Negative earnings and lack of information of startup business leads to abandoning traditional valuation approaches and develop new models to assess the value in order to justify the investments (we shall discuss these models in subsequent articles).
Startups are far earlier in their life cycles than established businesses, and have to be valued before they have an established market for their products/services. In fact, in some cases, startup businesses being valued have interesting ideas that could be a commercial success but have not been tested yet. The problem, however, is not a conceptual problem but related to estimation. The value of a business is still the present value of the expected cash flows from its assets.
For valuing a startup, correct assumptions, experience and correct judgement play a crucial role. At the end, it’s all about deal making. The value of a startup is a value at which both the promoters and the investors agree.