Valuation for Start-ups

Demystifying Valuation
Presentation at ForStartups

Dr. G. Sabarinathan

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

Two possible
outcomes

Founder Ownership
Founder Ownership After Sharing
Before Sharing


What happens when a company
issues shares to raise capital?

Demystifying Valuation ForStartups- Dr. G. Sabarinathan

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

No of shares 1,000

Value of Assets 10,000

Value per share 10

Founder's share 100%


Impact of Dilution
• Let us say until the issue of the Pre Diln Post Diln
additional 250 shares, all the shares Founder 100% 80%
were held by the promoters.
Investor 0% 20%
• The promoters held 100% of the
equity of the company. Total 100% 100%
• This represents 100% of the control Founder 1,000 1,000
as well as wealth of the company. Investor 0 250
• After the dilution the promoters Total 1,000 1,250
share 20% of the control as well as
the wealth of the firm. Value 10,000 25,000
• Why would the Founder agree to
such a deal?

Founder Ownership Founder Ownership
Demystifying Valuation ForStartups - Dr. G. Sabarinathan Before Sharing After Sharing

Equity Dilution
No of Shares • Value of the equity before funding
Pre Fund Post Fund is Rs 10,000
Rs/ lakhs Rs/ lakhs • Funding causes
• Drop in founder’s share of wealth
Founder 1000 1000
• Increase in value of firm’s equity
Investor 0 250 • Increase in founders’ wealth
Total 1000 1250 => “Growing pie” paradigm
% Equity • Dilution is financially wise for founder
Founder 100% 80% • Investor’s view is another story
• Deal will happen only if both see
Investor 0% 20%
financial sense in the deal, though….
Total 100% 100%
Value • Post Money Valuation: Value of firm / equity after
Rs/ lakhs Rs/ lakhs funding
• Pre money Valuation: Value of equity existing at the
Founder 10,000 25,000
time of funding
Investor 0 5,000 • Cash: Funding Amount
Total 10,000 30,000 • 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

Product Development Market Development Exit for Early
Activity Test Marketing Mfg / Sourcing Stabilisation Biz Expansion Investors?
Proof of Concept Mkt Development Mkt Development
Biz Model Management Management
Risks
Management Sourcing / Mfg Growth
Sales & Distribution Biz Model Competition
Economics Sales & Distribution Stage 4
Economics
Stage 3

Cash 100 500 2000
18- 36 months
Stage 2
Biz Growth

Stage I 12-24 months

0-12 months
Elapsed Time

Neuronautica Development Roadmap and Funding Plan

Valuation
Two sides
& of the
same coin
Return on Investments

The centre-piece of our approach to Valuation


The Way Investor’s Money Multiplies

Investment Multiple

Exit
Entry
Valuation
Valuation

Grow at expected rate of return

Rs 10 crores Rs 80 crores

8 times ~ 50% CAGR

12

Financial data for a similar company / transaction in the market

Profit / Share = 10
RoI = 10%
Price / Share
= 100
or
Investment

Valuation of Target

Profit / Share = 10 Price / Share
or = 100
Required RoI = 10% Investment in Target


Financial data for a similar company / transaction in the market

Share Value = 1000
Share Value / Re of sales = 2
Sales = 500

Valuation of Target

Estimated Share Value = Sales x Share Value / Re of sales = 1500 x 2 = 3000

10%


Performance – Return – Valuation Nexus
• Sales
• EBIDTA Financial Return
• EBIT Performance Expectation
• PAT

• Value / Sales
Valuation • Value / Profit
Multiple • Value / EBIDTA
• Value / EBIT

Equity
Valuation


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
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


17

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
Firm Promoter
Equity Idea RoundMoney Dilution Promoter% Value Wealth
• Promoters + 0 0 0 100% ? ?
• Investor(s)-1 Cash (for Product
Firm Promoter
Development)
Value Wealth
Equity Idea under RoundMoney Dilution Promoter%
• Promoters Development 1 100 25% 75% 400 300
• Investor(s)-1 +
• Investor(s) - 2 Cash (for completion Firm Promoter
+ product launch) RoundMoney Dilution Promoter% Value Wealth
1 100 25% 75% 400 300
Equity Business Expansion
2 500 20% 60% 2500 1500
• Promoters +
• Investor(s) - 1 Cash
• Investor(s) - 2 Firm Promoter
RoundMoney Dilution Promoter% Value Wealth
1 100 25% 75% 400 300
2 500 20% 60% 2500 1500

3 2000 10% 54% 20000 10800

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?

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

Rejection rate, importance and reasons by stage
*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

Investment
Initial interaction &
‘Research’ and Short- Business plan Due diligence and
sharing the business
Listing presentation Negotiations
idea
Effort*

23% 52% 29% 38% 10%
Rejection
Rate**

59% 76% 17% 14% 5% 5%
• Interest mismatch - • Too small market size or • Poor planning – unrealistic • Unrealistic valuation
projections
entrepreneur is pre-qualified and coached

inappropriate vertical or potential • Too high expectations from
geography • Easily replicable plan • Entrepreneur’s rigidness the management
• Financial, marketing or to modify plans as
Key Reasons for rejection

• Closer look contrary to
Most reasons can be avoided if

• Lack of consensus on
sustainability related initial perceptions proposed by the investor
• Communication issues governance, valuation etc
• Lack of confidence in • Unable to convince about
• Lack of track record of the • Legal issues
management as opportunity feasibility/ execution/
entrepreneur bigger than what was expansion/ sustainability • Adverse report on
• Vague or unstable plan management/ business
• Bad timing – too early or proposed initially • Unrealistic demands from
• Lack of expectation entrepreneur • Management’s rigidness to
‘me-too’ offering
• Not addressing a need/ non- alignment • Lack of confidence due to accept investor’s terms
viable, too opportunistic, • Competitive aspects inability to sustain cross-
too small a market potential • Unfavourable feedback on questioning
• Execution doubts management/ market • Legal issues & other
• Non serious entrepreneurs • ‘Wildcard’ deal spoilers ‘wildcard events’
walking in just to validate
the idea

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.
25 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

Demystifying Valuation 29

Valuation for Start-ups

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