valuation for start-ups

Dr. G. Sabarinathan

Demystifying Valuation

Presentation at ForStartups

December 1, 2012

What is Value? • Some common barbs about “value”

– “Value lies in the eye of the beholder.”

– “A cynic is someone who knows the price of

everything and the value of nothing.”

• Valuation is a systematic, disciplined approach, not a

science.

• Value = Monetary estimate of the benefit from owning an

asset or the right to exploit an asset

• Useful for

• Raising Capital

• Selling /buying / merging businesses and companies

• Public floatations

Demystifying Valuation ForStartups - Dr. G. Sabarinathan

Why Care About Valuation

• Share of Wealth

• Control

Founder Ownership

Before Sharing

Founder Ownership

After Sharing

Two possible

outcomes


What happens when a company

issues shares to raise capital?

Demystifying Valuation ForStartups- Dr. G. Sabarinathan

Equity Dilution Illustrated

No of shares 1,000

Value of Assets 10,000

Value per share 10

Founder's share 100%

Position of HiGrow Ltd., prior to raising any external equity


Impact of Dilution

• Let us say until the issue of the

additional 250 shares, all the shares

were held by the promoters.

• The promoters held 100% of the

equity of the company.

• This represents 100% of the control

as well as wealth of the company.

• After the dilution the promoters

share 20% of the control as well as

the wealth of the firm.

• Why would the Founder agree to

such a deal?

Pre Diln Post Diln

Founder 100% 80%

Investor 0% 20%

Total 100% 100%

Founder 1,000 1,000

Investor 0 250

Total 1,000 1,250

Value 10,000 25,000

Founder Ownership

Before Sharing

Founder Ownership

After Sharing Demystifying Valuation ForStartups - Dr. G. Sabarinathan

Equity Dilution No of Shares

Pre Fund Post Fund

Rs/ lakhs Rs/ lakhs

Founder 1000 1000

Investor 0 250

Total 1000 1250

% Equity

Founder 100% 80%

Investor 0% 20%

Total 100% 100%

Value

Rs/ lakhs Rs/ lakhs

Founder 10,000 25,000

Investor 0 5,000

Total 10,000 30,000

• Value of the equity before funding

is Rs 10,000

• Funding causes

• Drop in founder’s share of wealth

• Increase in value of firm’s equity

• Increase in founders’ wealth

=> “Growing pie” paradigm

• Dilution is financially wise for founder

• Investor’s view is another story

• Deal will happen only if both see

financial sense in the deal, though….

• Post Money Valuation: Value of firm / equity after

funding

• Pre money Valuation: Value of equity existing at the

time of funding

• Cash: Funding Amount

• POST–MONEY = PRE-MONEY+CASH


Neuronautica: The imaginary

case of a start-up with high

growth potential


The Story of Neuronautica • Founded by three neuro-psychiatrists with collective experience of forty years in

dealing with children with Selective Learning Disabilities

• Series of products lined up around FocuScience TM, the “Science of Focussing”.

• Products claimed to bring about slow transformation in the biochemistry of the

brain without the help of chemical-based pharmaceutical products.

• Collection of exercises, games and devices to help improve retentivity and

problem solving capability through improved concentration

• Target: Children in the age group of eight to fourteen years

• Non-pharma product: Does not require clinical trials or approvals

• Sourcing / manufacturing arrangements tied up

• Distribution / marketing possibilities under consideration

– Own channel of FocuZonesTM – high investment /risk / return/ model

– Distribution through toy stores, supermarkets and malls – Moderate

investments in advertisements, inventories and marketing collaterals

– Institutional marketing through schools – Low investment, low margin, low

volume model


Stage I

Stage 2

Stage 3

0-12 months

12-24 months

18- 36 months

Stage 4

Product Development

Test Marketing

Proof of Concept

Biz Model

Management

Sales & Distribution

Economics

Activity

Risks

Cash 100 500 2000

Mkt Development

Management

Sourcing / Mfg

Biz Model

Sales & Distribution

Economics

Mkt Development

Management

Growth

Competition

Market Development

Mfg / Sourcing Stabilisation Biz Expansion Exit for Early

Investors?

Elapsed Time

Biz

Gro

wth

Neuronautica Development Roadmap and Funding Plan


Valuation

&

Return on Investments

Two sides

of the

same coin

The centre-piece of our approach to Valuation


The Way Investor’s Money Multiplies

12 Demystifying Valuation ForStartups - Dr. G. Sabarinathan

Entry

Valuation

Exit

Valuation

Grow at expected rate of return

Rs 10 crores

Investment Multiple

8 times ~ 50% CAGR

Rs 80 crores

Profit / Share 10

Price / Share

or

Investment

100

RoI

=

=

Financial data for a similar company / transaction in the market

Profit / Share 10 Price / Share

or

Investment in Target 10% Required RoI

=

=

Valuation of Target

= 10%

= 100


Share Value 1000

Sales 500

Share Value / Re of sales =

=

Financial data for a similar company / transaction in the market

Sales 1500

10%

Estimated Share Value = =

Valuation of Target

= 2

= 3000 2


x Share Value / Re of sales x

Financial

Performance

Return

Expectation

Valuation

Multiple

Equity

Valuation

• Sales

• EBIDTA

• EBIT

• PAT

• Value / Sales

• Value / Profit

• Value / EBIDTA

• Value / EBIT


Performance – Return – Valuation Nexus

Angel Funding for Neuronautica

• The Angel’s questions

– How much money does NN require?

– How will I get my investment back with a rate of return?

Liquidity mechanism?

– How long will I have to remain invested

– What is an appropriate rate of return? How do I find a

benchmark for the rate of return in terms of similarity of

• Industry

• Stage of evolution

• Other risks – Liquidity? Capital Market risks

The answers to all of these questions impact the valuation process


Angel Investment in Neuronautica

17

Funds required Rs 100 lakhs

Angel’s expected exit 5 years after investment

Angel’s expected multiple on investment 8 times

Angel’s expected cash realisation on exit Rs 800 lakhs

Expected sales at the end of Year 5 Rs 320 lakhs

Valuation of NN at exit = Rs 320 lakhs x 10 Rs 3200 lakhs

% of exit valuation required = Rs 800 lakhs / Rs 3200 lakhs = 25%

To achieve his return objective the angel requires 25% equity for Rs 100 lakhs of cash

Valuation implicit in the transaction = Rs 100 lakhs / 25% = Rs 400 lakhs


Angel Investment in Neuronautica

Funds required Rs 100 lakhs

Angel’s expected exit 5 years after investment

Angel’s expected multiple on investment 8 times ~ 50% RoI

Angel’s expected cash realisation on exit Rs 800 lakhs

Expected sales at the end of Year 5 Rs 320 lakhs

Valuation of NN at exit = Rs 320 lakhs x 10 Rs 3200 lakhs

% of exit valuation required = Rs 800 lakhs / Rs 3200 lakhs = 25%

To achieve his return objective the angel requires 25% equity for Rs 100 lakhs of cash

Valuation implicit in the transaction = Rs 100 lakhs / 25% = Rs 400 lakhs

……..Needless this rests on many critical assumptions


Steps in Valuation

• Develop a sound business plan

• Be clear about all the underlying assumptions

• Incorporate the direct and indirect impact of the asset on the other

parts of the acquiring organisation

• Develop a set of forecast financials – P&L, Balance Sheet, Cash Flow

Statement

• Decide on appropriate method of valuation

• Estimate value

• Test Valuation under various scenarios

• Decide objective behind purchase – passive interest, joint venture,

strategic investment, controlling interest, as the case may be

• Add premium, if any, for achieving strategic or other objectives, such as

“control”.


Beyond Angel Funding for Neuronautica

• On similar lines as in the angel round the company expects to raise a

Series A and Series B round of funding as indicated below

Series A

• Amount Rs 5 crores

• % equity issued 20%

• Valuation Rs 5 crores / 0.20 = Rs 25 crores

• Series B

• Amount Rs 20 crores

• % equity issued 10%

• Valuation Rs 20 crores / 0.10 = Rs 200 crores

20


Dilution @ Neuronautica Equity-Promoters Idea

Equity

• Promoters

• Investor(s)-1

Idea

+

Cash (for Product

Development)

Equity

• Promoters

• Investor(s)-1

• Investor(s) - 2

Idea under

Development

+

Cash (for completion

+ product launch)

Equity

• Promoters

• Investor(s) - 1

• Investor(s) - 2

Business Expansion

+

Cash

RoundMoney Dilution Promoter%

Firm

Value

Promoter

Wealth

1 100 25% 75% 400 300


Firm

Value

Promoter

Wealth

1 100 25% 75% 400 300

2 500 20% 60% 2500 1500


Firm

Value

Promoter

Wealth

1 100 25% 75% 400 300

2 500 20% 60% 2500 1500

3 2000 10% 54% 20000 10800


Firm

Value

Promoter

Wealth

0 0 0 100% ? ?


Challenges in Valuing Neuronautica • Apart from lab level evidence hardly any information on

• The effectiveness of the product in the field

• Acceptance of the product

• Challenges in sales and distribution

• Untried management team

• How far can they take this business?

• Can you find people beyond the founders’ ability?

• Will the founders agree to step aside if found necessary?

• The economics of the business under different business / operating models

• How will the investor realise his returns?

• The virtues of staged financing

• For the entrepreneur: Helps demonstrate value

• For the investor: Helps discover value / uncover risks

• The trouble with staged financing: How will the market respond when the

company needs to raise money as planned?


Final Questions and Thoughts

1. What drives Valuation

2. How is the divergence in the outlook valuation addressed?

3. Does Valuation depend on other terms of a deal?

4. Does Valuation have to be frozen at the time of raising a

round of funding?

5. Do deals fall through on Valuation?

6. Does modelling help improve Valuation?

7. How much effort / time does one spend modelling valuation?

8. Where does one find the information required for Valuation?

9. How reliable are published information on Valuation?

10. Is it worth turning to a professional for Valuation? Demystifying Valuation ForStartups - Dr. G. Sabarinathan

Drivers of Valuation • Environment Related

– Macro-economic outlook – Industry Outlook – Liquidity Overhang

• Firm Related – Fundamentals of the firm, esp. strategic aspects.

• Deal Related – Stage of investment and expected investment horizon – Relative size of exposure in relation to the size of the

deal. – Previous round investors’ expectations – Exit prospects and path

• Valuation Trends – Comparable deals. Caution : Compare likes. – Public market valuations and liquidity



25

Rejection rate, importance and reasons by stage

Initial interaction &

sharing the business

idea

‘Research’ and Short-

Listing

Business plan

presentation

Due diligence and

Negotiations

Initial stages consume over half the effort and filter-out just 76% of the deals, suggesting that there is an

opportunity to improve the efficiency of entrepreneur-investor interaction.

Effort

*

Reje

ctio

n

Rat

e**

K

ey

Reas

ons

for

reje

ctio

n

23% 29% 38% 10%

59% 17% 5%

• Interest mismatch - inappropriate vertical or geography

• Financial, marketing or sustainability related

• Communication issues • Lack of track record of the

entrepreneur • Vague or unstable plan • Bad timing – too early or

‘me-too’ offering • Not addressing a need/ non-

viable, too opportunistic, too small a market potential

• Execution doubts • Non serious entrepreneurs

walking in just to validate the idea

• Too small market size or potential

• Easily replicable plan • Closer look contrary to

initial perceptions • Lack of confidence in

management as opportunity bigger than what was proposed initially

• Lack of expectation alignment

• Competitive aspects • Unfavourable feedback on

management/ market • ‘Wildcard’ deal spoilers

52%

76%

• Poor planning – unrealistic projections

• Entrepreneur’s rigidness to modify plans as proposed by the investor

• Unable to convince about feasibility/ execution/ expansion/ sustainability

• Unrealistic demands from entrepreneur

• Lack of confidence due to inability to sustain cross-questioning

• Legal issues & other ‘wildcard events’

• Unrealistic valuation

• Too high expectations from

the management

• Lack of consensus on

governance, valuation etc

• Legal issues

• Adverse report on

management/ business

• Management’s rigidness to

accept investor’s terms

Mo

st r

easo

ns

can

be a

vo

ided

if

en

trep

ren

eu

r is

pre

-qu

alifi

ed

an

d c

oach

ed

*Effort measured as dollar value, as perceived by the respondents

**Rejection rate – of a total of 100 approaching the VC, the number rejected at this stage

14% 5%

Invest

men

t

Source: Stern Fisher-IVCA Presentation

Observations on Funding and Valuation

• Multiple rounds are not just important but inevitable for early stage, high

growth businesses Control vs Wealth Trade-off

• Multiple stages mean progressive dilution

• Successful development of investee means wealth of founders’ as well as

early round investors grows in spite of decline

– Equally, unsuccessful development could mean “washing out” of

incumbents’ wealth

• Challenges

– Anticipating requirement of funds: Too much vs Too little

– Firming up key strategic choices

– Calling capital market conditions

– Bases of Valuation

– Forecasting performance and “Incentives”


Information on Valuation

• Public Information easily available now

– Websites of ET, Moneycontrol…

– Commercial databases: Prowess, Capitaline,

Bloomberg

• Private Information hard to come by

• Newspaper reports

• Databases like Venture Intelligence, VC Circle

• Specialised Intermediaries

– Caveat: Be careful about special terms

THANK YOU


Agenda

• What are we valuing?

• What happens when a company issues new shares to raise

new funds?

• Financing a high growth growing start-up: A flight of

imagination

• Valuation Challenges

• How do VCs and angels carry out valuation

• Steps to Valuation

• Factors Influencing Valuation

• Closing Thoughts

29 Demystifying Valuation ForStartups - Dr. G.

valuation for start-ups

Documents

demystifying

cash valuation

sharing founder

sabarinathan

equity promoters

rs 100 lakhs

staged financing

return objective