Startup Valuation – How Is It Done?

In this Blog Post, Charvi Arora, a student of University of Petroleum and Energy Studies, Dehradun, tells us how a the valuation of a startup is done and further enlightens as to how a startup is established.

Valuation of a Startup

To start with, let’s look at the basic definition of a Startup. So, a Startup is a newly established business looking forward to getting itself placed in the market and continuing further in motion.

It is quite easy for an artist as compared to a person belonging to a science background to value the startup because it is believed that valuing a startup is mainly in the domain of an artist. It is necessary that we put a value on our startup investments to generate liquidity. Since valuation of a pre-revenue company is often one of the first points of contention that must be negotiated with investors and entrepreneurs. Entrepreneurs want the value to be as high as possible and investors want a value low enough for them to own a reasonable portion of the company for the amount they invest. Potential investors and entrepreneurs prefer to use several methods to value a startup because no single method is useful every time. Multiple methods also help in the negotiation process because an average can be determined from among them and it rather becomes less time consuming.

The biggest determinant of a startup’s value are the market forces of the industry and the sector it falls in, which include the balance (or imbalance) between demand and supply of money, and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.

Big startups in India as of today are Myntra, Jabong, Freshdesk, Zomato, Olacabs, Book My Show, Oyo Rooms, Snapdeal, Bigbasket, Paytm, Dropbox, Instagram, etc. which have gained a huge amount of popularity and are still growing at a very fast pace. Startup companies have short operational histories and little historical financial data. Usually in a business, the valuation specialists typically use historical financial data to extrapolate the future value of a business. Recently, the government officially launched the ‘Startup India’ programme which was first mentioned by the Prime Minister on the 15^th of August, last year.

According to a report given by The Hindu, the plan comes at a time when the startup ecosystem in the country is witnessing an exponential growth. As per NASSCOM’s “Startup-India: Momentous Rise of Indian Startup Ecosystem” report, India ranks third globally with over 4200 startups.The government has shown their interest to support the startup ecosystem and Startup India is expected to take it ahead with the introduction of key policy reforms. According to Nilotpal Chakravarti, AVP of Internet and Mobile Association of India, “Over the last one year, the government has been steadily building a conducive atmosphere for encouraging start-ups in India. Initiatives like Digital India and Make in India are the biggest enablers providing a boost to startups.”

We should know what our business is actually worth, i.e., if it’s worth being is higher than we are thinking or if it is overvalued by us. To decide this, certain steps are to be taken into consideration and they are:

Depends upon the market

It depends upon the investors; whatever they’re telling is what the startup is worth. If we think that our startup is worth more, and we are unable to raise a certain amount of money, we have to accept the valuation that the investors have given it.

If we raise money from our relatives and friends rather than professional investors, it’s possible that our company has been overvalued or undervalued (more likely, overvalued). Therefore, if we have persuaded our rich uncle to purchase shares in our business at Rs.20/share, it doesn’t mean that the investors will also pay that amount to buy that share even if our business is growing at a good rate.

When do we tell the market what is our worth?

This case is very rare in a startup as they don’t have a history of financial performance on which the investors can valuate it. Therefore, it’s always up to an entrepreneur to develop a strong procedure for valuing the company at a higher level based on other comparables.

Startups require a more creative methodology that considers, among other factors:

Quality of management
Value of comparable companies
Industry prospects
Stage of development
Value of company IP
Working capital requirements

The basic Stages behind a Startup

Stage 1

1. Inspire:

This is the stage where the entrepreneurs get inspired from an idea and want to establish a startup. They try to initiate it and follow certain ideas that have inspired them. The startup media typically provides centralized local startup listings and news.
It also includes inspirational events which welcome the people into their community and inspire those with ideas to launch a company. Some examples are Startup Weekend, University Events, and Inspirational Meetups.

2. Educate:

In this stage, an entrepreneur learns and gets himself more acquainted with the field in which he is going to establish a startup and collects all the necessary information which is required.
These events serve to educate rather than inspire. Training and feedback with a certain idea in hand, bootcamps help in aspiring entrepreneurs build more.

3. Validate:

When in the last stage, in order to execute the startup, the entrepreneur validates the new business and brings it into comparison with the already set up businesses.
Team formation for startups is the key. It should only include resources that specifically facilitate networking.

Stage 2

In this stage, entrepreneurs establish and formalize the company, develop their product, get feedback from customers, and prepare for the next step.

1. Start:

It includes resources to help entrepreneurs set up the legal and financial frameworks for their companies, like local law firms and banks that specialize in addressing the unique challenges of startups.
Co-working and flexible workspaces can provide a good breeding ground for new companies.

2. Develop:

As a company begins to grow, they often need resources to help them set up their infrastructure (accounting, HR, recruitment, production, etc). This section can include accountants, software development houses, and more.
PreSeed funding is a big milestone for most startup teams.This includes Startup Weekend Next and workshops.

3. Launch:

The next step in the equation for most ecosystems is a local accelerator, like TechStars, Seedcamp.
Whether a company goes through an accelerator or not, they often need a way to present their company to a large number of investors in order to gain a large seed investment.

Stage 3

Here, a startup proves their utility, receives recognition and scales up. This usually requires funding and other resources to drive growth.

1. Recognition:

Many ecosystems have ways to connect professional investors with founders, like events, groups, and association.
The major media can play a role in the startup ecosystem as well, by providing exposure for companies to mainstream audiences.

2. Funding:

These investors focus on the seed-stage. These investors typically participate in the funding stage and beyond, such as institutional venture funds.

3. Growth:

With capital in hand, a company will often need to invest in infrastructure to grow. This includes expenditures like office space, HR, business insurance, and more.
In many cases, capital-rich companies will also look for new areas of growth such as new product lines or international markets. Consultants, corporate accelerators and growth accelerators can typically help provide assistance in local markets.

The value of your startup depends on the investor; if he’s willing to pay more for your company depends on the following factors:

The startup is in a flourishing sector:

Investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.

If the management team comprises of professionals from all fields:

A good team gives investors good faith that the team can execute further and grow wisely in the market.

The product to be introduced is a functioning product:

It becomes easy for the market to adapt the new product in a lesser time and certainly for the investors to invest in it.

Negatives that could lead to decline of a Startup

It is in a sector that has shown poor performance.
It is started in a sector which is highly commoditized, with little margins to be made.
It is in a sector with a too many competitors and little differentiation between them.
The management team has no record and the professionals are missing from its team.
The capital budgeting is really acute.

If we set up a survey to ask people what is the basic drawback, of a startup not being a success is ‘Lack of capital’. However, in our experience working in nearly 100 markets across the globe, ‘lack of capital’ is nowhere near being the biggest hindrance to startup community growth.

Consider the following sequence of events, which are considered to be very helpful:

New capital is required to grow a local startup ecosystem, either by the government or by foreign investors. This money needs to be allocated fairly quickly.
As a result, these organizations start :

Creating exclusive relationships with others in the ecosystem
Vertically integrate (ex. co-working spaces that used to partner with accelerators now create their own accelerators).

Almost overnight, a once collaborative ecosystem becomes overly competitive and fragmented.

Startup Ecosystem

Taking in consideration the ‘The Startup Ecosystem’ (a startup ecosystem is formed by people, startups in their various stages and various types of organizations in a location, interacting as a system to create new startup companies), they are controlled by both external and internal factors. External factors like financial climate, big market disruptions and big companies transitions control the overall structure of an ecosystem. Start-up ecosystems being dynamic entities, they are initially in formation stages and once established are subject to periodic disturbances, passing afterwards to the recovering process from some of those past disturbances and then flourishing like a fully established business in the near future.

Start-up ecosystems in similar environments but located in different parts of the world can end up doing things differently simply because they have a different entrepreneurial culture. The introduction of non-native people knowledge and skills can also cause substantial shifts in the ecosystem functions. In addition, resources like skills, time and money are also essential components of a start-up ecosystem. The resources that flow through ecosystems are obtained primarily from the people and organizations that are an active part of those startup ecosystems. Interactions in the form of events and meetings between organizations and different people play a key role in the movement of resources through the system helping to create new potential startups or strengthening the already existing ones and hence influencing the quantity of startups build. Failures of start-ups release people with improved skills and time for either establishing a new start-up or joining an already existing one.

Startup ecosystems are generally defined by the network of interactions among people, organizations and their environment. They can come in many types but are usually better known as startup ecosystems of specific cities or online communities ( it is often said that due to social networks, the entire globe is just one big network of startup ecosystems).

To conclude, the only strategy to be adopted by the Startup entrepreneurs should be “Go big or go home”.

Raise as much money as possible at the highest possible valuation, spend all the money fast to grow as fast as possible. If it works you get a much higher valuation in the next round, so high in fact that your seed round can pay for itself. If a slower-growing startup will experience 55% dilution, the faster growing startup will only be diluted 30%. So you saved yourself the 25% that you spent in the seed round. Basically, you got free money and free investor advice.

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