Startup Valuation: VC Method

In an earlier post I had shared that there are number of methods used to value startups. I had promised that I will detail the methods. Here is the first of those methods listed – ‘The Venture Capital Method’ or VC Method.

The introduction of this method is attributed to Professor William Sahlman, who wrote about it in a 1987 case study. Professor Sahlman is famous for his widely used article ‘How to write a great business plan’ in the Harvard Business Review. I have used it as reading in some of my courses too! That’s enough for background and validity!!

The VC Method

The formula used in this method are simple:

Pre-Money Value = Post-Money Value – Investment

Post-Money Valuation = (Terminal or Harvested Value) / (Expected Return on Investment)

Now you need to know what these terms mean, isn’t it? Here they are:

Terminal or Harvested Value: This is the value that the investor expects the startup to have when his/her stake is sold. Now, this could be the next round of investment or after a couple of rounds of investment or when the company goes public or it gets acquired by another company. Whatever be it, the investor must know what will be the value at the point of sale. Usually early stage investors stay only till a couple of rounds of investment. Hence they consider only the value until then.

How do we calculate Terminal Value?

Ans: Any usual finance text book will teach you methods to do this. Simple back of the envelope methods include: number of times sales or Industry P/E times Profit, etc. You can get these data from industry analysts or reports or historic datasets or even from angel associations. Recent investment records from new items can also provide pointers. Always use more than one method and then take average to improve your odds.

Expected Return on Investment (ROI): This is simply the rate of return that the investor expects to make on his/her investment. While it may be easy to think it terms of percentage, strangely investors of this category (startups) think in terms of ‘number of x’s’ or number of times they expect their investment to multiple. For ex: 10x means 10 times, 20x means 20 times and so on. In Angel investing, it is normal to see investors talk about 10x-30x returns. It varies a lot. But considering the risky nature of these investments, one is bound to expect high multiples.

Post-Money Valuation: The value of the startup including the investment made by the investor.

Pre-Money Valuation: This is the value of the startup just before the investment is made by the investor.

Investment: This is the amount of money invested by the investor into the startup.

Illustration:

A startup in software wants to raise 10lakhs. It expects to touch a revenue of 10 Crores in 2 years.

Knowing that software startups are valued close to 2 times sales, the investor expects the harvest value to be about 20 crores. Assuming an average return of 20x, the investor calculates post-money valuation to be = 20/20x = 1crore. Therefore pre-money value is 1Cr – 10Lakhs = 0.9Crore.

Deviation: Lets just understand pre and post money valuation here: If investor considers 1Crore to be post money valuation, then it includes the investment (10lakhs) too. Therefore entrepreneur’s share is 90% and investor’s share is 10%. But if the investor considers the 1Crore as pre-money valuation, then the post-money valuation becomes 1.1Crore. Then the entrepreneur’s share becomes 88.9% and investor’s share becomes 11.1%. Hope you get it!! While the difference seems too small, the trouble is not in the present. Just imagine when you become Infosys at its peak or Flipkart at its peak. Do you think 1.1% ownership can make a difference? I hope I don’t have to clarify this 🙂

Continuing with our example:

So, considering that this company in our example is valued at 1Crore post-money valuation, how much percentage should the investor seek to get his 10Lakh investment. It seems that if he takes a 10% stake in the company for his investment and everything goes as per his / her calculation, they will get a 20x return when they exit after 2 years.

This method gets complicated when there are more rounds of investment before harvesting! The current investor will need to factor the new investments too before deciding on how much value the company will have and what stake they will need to keep prior to making an investment. It mathematics. As one of the practitioners suggests, one of the quick methods is to reduce the value by the level of dilution expected in the future rounds. If you intend to dilute 50% before harvest, then decrease value by 50% and so on.

While one can keep on complicating the math, I hope entrepreneurs will get an overview of the method. As with any skill, once you make a beginning (and if it is your cup of tea) you will enjoy the complexities and play the game. I hope this blog will help you move closer to playing the real game.

Try it. Its fun.

Finance for Entrepreneurs: How to value startups?

Valuation is a funny game, especially when it comes to startups! While speaking at a recent panel I was intrigued by the number of times companies that were going after ‘valuation’ rather than sustainable ‘value’, were being quoted. This led me to raise the question – Should entrepreneurs go after ‘value’ or ‘valuation’? But how are we to value startups? Is there any particular method? During a recent competition where I judged (along with an entrepreneur) a valuation competition I realised that almost all students participating in the event were ill-equipped to value startups. Read here about the experience.

I find that even faculty of accounting and finance are not exposed to the continuously evolving approaches to valuing startups. While it is easy to dismiss most of these methods as non-scientific, one must acknowledge that the billions of dollars being invested are using these methods. Hence it makes sense to expose ourselves to them. This is not a tutorial on how to conduct the methods, but a consolidated list of many widely used methods to value startups. While I intend to detail every one of them as individual posts later on the blog (Under the Series: Finance for Entrepreneurs), the proactive and inquisitive ones can search online and learn them too.

While there could be many variation and anymore, here are at least nine methods to value startups:

  1. Venture capital method
  2. Dave Berkus Method
  3. Scorecard Method
  4. Risk Factor Summation Method
  5. Asset Value Method
  6. Discounted Cash Flow Method
  7. Earnings Multiple Method
  8. Cost of Replacement Method
  9. Comparables Method

While the first five methods are fairly logical to use with startups, the remaining four are almost impossible to be of value. But surprisingly many, if not most, students of finance use the bottom four in competitions and routine calculations.

Try your hands at exploring some of these methods or wait for a few weeks and I shall attempt to detail every one of them and justify their use (non-use) with startups.

Happy learning!

Finance for Entrepreneurs: Value and Valuation

While today we speak of companies such as Flipkart and Zomato, most of them seem to be running a ‘valuation’ game. But according to my understanding entrepreneurs must run a ‘value’ game. While the two should be related, there is a huge difference between the two.

Value – is what is created by the entrepreneur for a consumer. In the process the entrepreneur gets rewarded. All of this if done in a sustainable way, the business runs for a long period of time. Rare, but examples exist.

Valuation – is when an entrepreneur attempts to create value for themselves and their investors. They provide consumers services to make this happen. If the business makes through the difficult mathematical puzzle of numbers, it exists, else death is certain. Examples are a plenty, but exceptions exist.

If a startup create value for its customers, over time it is rewarded by valuation too! But if valuation is the focus, value is at times compromised, industries undergo turmoil and there is a shakeout of good players too. This is not very good for the long term.

Last week when I was speaking at a panel discussion I was reminded of this: why creating business models and identifying value are more important than raising money.

I hope entrepreneurs and startups understand this and live it. It is important considering the fact that, even if all the Venture Capital money flows in and gets invested, the number of startups getting funded will be a minuscule portion of the startup population. And more importantly, entrepreneurship is a career, a journey, not just a race or a competition.

Think and decide to take the plunge into entrepreneurship. Its fun and fulfilling! I can vouch for it both from my personal experience and of having groomed many.

Happy entrepreneuring!

Startup Valuation seems a funny game

I teach a number of classes on entrepreneurship and startups across Asia. Almost every group wants to know about how valuation is arrived at. Though I do justice to the various methods of arriving at ‘valuation’, I insist of letting them know that the practice is fairly disconnected from theoretical classroom discussions. The theoretical models help gain a range of values and one has to add the euphoria of the market, emotions of those involved etc before arriving at the final value. One new item caught my attention and reminded me of our classroom discussions.

News item titled ‘Lyft Receives $500 Million Investment From General Motors to Develop Self-Driving Cars’ (Link: http://www.inc.com/associated-press/lyft-general-motors-500-million-dollar-investment.html?). In particular this paragraph caught my attention.

‘Following its latest round of fund-raising–which also included a $100 million investment from Saudi Arabia’s Kingdom Holding Co.–privately-held Lyft set its value at $5.5 billion. The company expects revenue of around $1 billion this year. By comparison, GM is valued at $53 billion and earned $153 billion in revenue in 2014.’ (quoted as is from the above linked article. purely for academic explanation)

After reading it a few times, I thought it was to be shared in valuation classes. Is there really a relationship between revenue and value? If valuation is really about the future, how much of it can truly be captured? And if everything is captured, then where is the fun in valuation?

It is this uncertainty and varying perceptions of it, that make a market possible. In such a market, valuation thrives. We still have to learn the techniques, but remember that what happens in the world will have an irrational component added to the mathematics.

Happy Thinking!!

Finance for Entrepreneurs: What are Assets?

All of us like to accumulate assets. This inherent nature exists amongst entrepreneurs as well. Hence it is not uncommon to see entrepreneurs and small business owners buy assets when they have money. But this kind of asset creation has not helped too many entrepreneurs and small business truly scale to their potential. Why do you think this happens?

First things First! Let us understand what ‘assets’ are, from an accounting perspective – they are objects that we purchase ownership to. Businesses attempt to own things – equipments, land, buildings, cars, etc.,. All of these appear on the ‘Asset’ side of the balance sheet. But on the asset side you also see such entries – cash, inventory, receivables, etc.,. While all of the above are what a company owns, they fall under two categories: short term assets and long term assets. The short term assets are also called ‘current assets’. These are assets which the business can realise value from in the near term (typically one accounting period, usually one year). For example: cash, receivables, etc.,. The long term assets are those that the business derives value from over a long period of time (multiple accounting periods, usually more than one year). For example: land, building, equipment, vehicles, etc.,.

Assets are created by enterprises by incurring expenses. But these expenses are not fully chargeable to the Profit/Loss Statement (https://rajshankar.wordpress.com/2013/11/01/finance-for-entrepreneurs-what-is-a-profit-loss-statement/ ) in the same period in which the expense is actually dispensed with. The reason for this is that, to ensure fair accounting practice. Hence it is only good to spread the cost of the asset over the period through which it provides value to the company. Lets take an example: An equipment costs the company 10 lakhs. The estimated life of the equipment is say 10 years. If that be the case, the enterprise will derive value from the equipment for 10 years, utilise the equipment to produce for 10 years. In this case, how is it fair to charge the entire 10 lakhs to the Profit/Loss statement in the year in which it was incurred. One it doesn’t seem fair because the equipment is contributing to the revenue over the ten years and second, if charged in one year will make that year’s performance look poor. This will also lead to avoidance of taxes as every year the enterprise can simply keep purchasing assets to show expenses!

Hence it has been agreed that the cost of the asset will be charged over the life time of the asset. This yearly charge is called depreciation, a non-cash expense. Only the charge that is applicable for this year is taken to the Profit/Loss Statement as expense (Depreciation). It is called ‘non-cash’ expense simply because it is not actually spent in the year in which it is charged.

What kind of assets should start-ups try to create? This requires some thinking. But a couple of simple rules can help: Create assets that can help the enterprise generate revenue in the future. Create assets only when they cannot be borrowed, begged for, or stolen. (https://rajshankar.wordpress.com/2014/05/13/entrepreneurial-skills-beg-borrow-steal/ ) Now this varies from business to business. In case of a IT Services enterprises, it could be intellectual property, or people, R&D, Organisational knowledge, etc. In the case of a clothing company, it could be machines, factory space, etc.,.

Well thought of investments into assets can help a company grow fast. If investments are not prudent, businesses will end up with assets which may become valuable but will not enrich the future revenue generation capacity of the enterprise. Example: A small IT firm invests in a large land and building. While the property will appreciate in value, it does not necessarily translate into future revenue from software services!

Think about it!

Finance for Entrepreneurs: Importance of Gross Profit

Revenue in a large way is a clear measure of what customers perceive as value. Hence revenue is a tangible way of evaluating value delivered. If we can safely assume that revenue is an indication of ‘value created’ for the customer, then we can also safely assume that gross profit is a reflection of ‘value captured’. These are not accounting terms, but they are reflective of how customers value a product or service and how business creates value for itself. This makes ‘Gross Profit’ an important metric to track in any business.

On the Profit/Loss Statement when we deduct ‘Cost of Goods Sold’ from Revenue, what remains is called ‘Gross Profit’ or ‘Gross Margin’ or ‘Contribution’. ‘Cost of Goods Sold’ refers to the costs incurred directly in the creation of the products or service, thereby the revenues.

‘Gross Profit’ is a widely tracked metric. This is primarily because ‘Gross Profit’ refers to the value that the business is able to create for itself in creating and delivering value to customers. If the ‘Gross Profit’ is high, then it means that people are willing to pay a premium to purchase the benefit. For example: people understand that the cost of manufacturing an iPhone is a lot lesser than the price that they pay for purchasing it, but customers are willing to allow Apple to make the money for creating and delivering the iPhone.

A large ‘Gross Profit’ also means that the business has enough margin to cover its remaining costs and also invest into the futuristic expenses. Growth requires money. Money typically comes either from the business operations itself or from debt or from equity investors. If the business has a large ‘Gross Profit’ then there is enough money to invest for future growth too. But if the business does not have enough ‘Gross Profit’ then the business has to raise money (debt / equity) to fund the future growth. Money from business operations (‘Gross Profit’) is free money for the enterprise, while the money from external sources comes at a cost.

Investors also show interest in knowing ‘Gross Profit’ simply because it is a reflection of the economic power of the product or service. This means that as the business scales the volume of margins will keep improving the self-financing ability of the business. This will reduce the need to raise or borrow funds from outside. This results in the existing investors’ valuation growing by leaps and bounds.

Thus for a number of reasons understanding and tracking ‘Gross Profit’ is an important aspect for every entrepreneur.

Think about it!

Finance for Entrepreneurs: What are Expenses?

Expense is what a business incurs to produce and deliver its services and thereby earn revenue. It is therefore part and parcel of every enterprise. Expenses are usually of three types:

  1. Operating Expenses
  2. Capital or Investment Expenses
  3. Financial Expenses

1. Operating expenses are those that the business incurs to create and deliver the product or service. These are typically those expenses that deliver their value within a short period of time. For example: Salaries of employees is a monthly operating expense. It delivers its value namely employee effort in that very month. Other examples of operating expenses include rent of office and/or factory, utility bills (electricity, telephone, conveyance) etc.

2. Capital Expenses are those that result in the business gaining benefits over a longer period of time. For example: Purchase of expensive machinery that has a life of 10 years. Such a machine may incur a huge cost that may have to be funded through a loan if the business does not have enough internally generated funds. In any case accountants amortize the expense over the ten years to reflect the usage of the machine by the business. Other examples of capital expenses include land, machines, computers, furniture, etc. Based on the possible life of the asset, the expense is proportionally amortized. Amortization means dividing the cost of the asset across its useful life in proportion to its utilization.

3. Financial Expenses are those that the business incurs to ensure that the operating and capital expenses are paid for. Examples of financial expenses are interest on loans or debt. Loans may be short term and long term in nature. Dividends paid to owners are not an expense to the company.

Expenses are incurred by the business so as to generate revenue. Hence when an expense is made it normally is deducted from the revenue in the Income Statement (https://rajshankar.wordpress.com/2013/11/01/finance-for-entrepreneurs-what-is-a-profit-loss-statement/ ). If the expense is of a capital nature, then the expense is first taken to the Balance Sheet as an asset and based on the life of the asset a small portion of that spending is brought to the Income statement at the end of the year as an expense for that Operating Period. Financial expenses typically affect the Balance Sheet (https://rajshankar.wordpress.com/2013/11/08/finance-for-entrepreneurs-what-is-a-balance-sheet/ ) first as an increase of liability of reduction of asset. Interest paid on debt is typically brought to the Income Statement for the relevant accounting period as an expense.

Let us take a more detailed look at expenses and their impacts on the financial statements in a later lesson. But for now try to understand what these expenses are and how these are different from each other.

Try it: Ask your accountant for a copy of your latest Income Statement and try to segregate the expenses based on the above three types.