People who have recently been in touch with news related to startups might have recently have heard about all the furore over startup valuations. From Snapchat’s 20 $ billion valuation to Flipkart’s recent fall in valuations to Uber’s 66 $ billion valuation, startup valuations have been a hot topic for media in the recent times and a lot is being said about the logic behind these valuations. Well we won’t give you our take on these. Instead we hope to help you make your own opinions, so if you have been wondering how these are actually calculated just sit back and read our second article in the series eDC101: Startup Valuation
So what actually are Startup Valuations?
Valuation is simply the value of a company. The Value of a company is evaluated based on the need to give a certain price point to the value added by the startup to the existing system. This is an extremely essential exercise for both the entrepreneurs and the investors as it determines the price of buying into a certain amount of equity from the shareholders. This base is used by the entrepreneurs for raising funds for the company and by the VCs to evaluate how much equity can be traded for the funding.
So before we jump right into the mechanics of how these are actually evaluated let’s just understand the economics of valuations from an entrepreneur’s perspective.
There are 2 types of valuations:
Pre-Money Valuations and Post- Money Valuations:
Lets understand this with the help of an example.
Let’s say company A has developed a prototype of a product . Now the company determines it need Rs.2cr of capital to develop and market the product for consumers. It approaches VCs and angel investors for the same. Now one of them agrees to fund them and gives them a term sheet (The term sheet is the document that outlines the terms by which an investor (angel or venture capital investor) will make a financial investment in your company.) which has the following terms of investment:
“The LLC A will receive an amount of Rs2cr. at a post-money valuation of Rs10cr. ”
Didn’t understand all the technical jargon in the above statement? Well worry not! Let’s break it down and try to understand what it really means.
In simplest terms it means the investor will receive 1/6th of the company’s shares.
HOW?- Let’s Work it Out
The investor determined the company and it products worth Rs.10cr. (Let’s for the time being forget how).Post money means that the amount of equity that the investor receives is valuated post the funding. This means 2/(10+2) = 1/6 of the equity. Of course there are other terms of investment such as preferred stock options, Terms of dilution for future rounds etc. but this is what it broadly means.
Now then what is Meant by Pre-Money Evaluation?
It simply means the investor receives equity without adding the funded money to the value of the company. In that scenario the investor would have received 20% equity. (2/10)
Now that we understand the basic nitty-gritty’s of valuations, without much ado let’s directly jump into the mechanics of valuations.
image source: http://fundersandfounders.com/how-startup-valuation-works/
So Really How are these Evaluated?
Startup Valuations is an art rather than a science and is the reason behind the variations behind difference in opinions and even different valuations by different firms. There is a lot of room for assumptions and educated guesses. (Yes you read it right! Guesses!.)
General this exercise is carried out by corporate lawyers, accountants and VCs. Now all of them follow different processes and hence if you get startup valued by them you will definitely find difference in their results. Lawyers are generally hired by the startups looking to raise funding and go by the potential of the team, future cash flow projections and product potential, and often tend to overvalue the company in order to get the possible deal for the company. Accountants generally rely on hardcore data and current revenues etc. which in a startup isn’t meaningful as the real value of a startup lies in its potential for growth. They therefore tend to undervalue the company based as they underestimate the future values of the company.
VCs generally rely on cash flow projections, market sizes etc. to value startups.
Though everyone has their own methods of valuations, there are some broad parameters which everyone uses and we are gonna list them now:
- Traction:Quite intuitively a fast growing company will be more valuable than a company whose rate of growth is stagnant. Apart from the rate of growth the base for that groth rate is important. Apart from that experienced investors will obviously look at the metrics such as daily active users, rate of retention, churn rate etc.
- Reputation and Experience: The brand image of the company and the founders matter a lot and the amount of funding they get at what valuations is often determined by that. Often serial entrepreneurs as well as established companies starting new verticals get higher valuations. Ex. CureFit started by (senior) ex-flipkart management recently got 15$ mn. Funding within 6 months at a high valuation.
- Revenues: Even though we stated that the real value of a startup lies in its growth potential and viral coefficient, the current finances of the company do matter. If the unit economics of the business aren’t too rosy, then obviously the valuations won’t be too high. If the business is in a bad shape even though it might be raising huge amounts of revenues but if its burn rate is uneconomical then obviously the valuations would be affected.
- A case in point is that of Jabong. 3 years ago it was valued at 1$ billion and was almost bought by Amazon at that hefty price. Fortunately for Amazon that deal never went through and valuations were as low as $ 100 million about 6 months back. Now that the company reported profits , albeit minor($0.2 million), for the first time this quarter there are again talks about it being priced at $300 million and reported negotiations for sale at that hefty price.
- Market Size: If there is a huge potential or existing market for your product (quite logically) your company will be valued more owing to the possible high cash flow projections given reasonable amount of market penetration.
- Valuations of competitors: If the companies in a similar business as yours is valued higher and your fundamentals are stromg and comparable your valuations will be as a rule of thumb higher. An example is that of Snapchat. It has been gaining a lot of traction lately and was valued at $20 billion, while SpaceX perhaps doing a much more valuable and revolutionary business is valued at $12 billion. While people who understand the business of the companies might be bewildered at this but this is a case in point for the above fact. SpaceX has no real competitors except BlueOrigin and govt. agencies which haven’t been valued yet and hence an absolute valuation is extremely difficult. Snapchat’s valuation on the other hand is based on valuations given to other social media companies such as facebook, Whatsapp etc.
While there are other parameters that are used in startup valuations these are essentially the ones which can broadly determine the price of your company.
We hope you enjoyed learning about the fascinating world of startup valuations and continue reading our series. You can send your feedback to firstname.lastname@example.org about any shortcomings you found in the article and we will definitely incorporate those in our future articles.
Recommended Reading: Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Dick Costolo
Author: Kunal Aggarwal