Ah, Valuation!!
Valuation is a rather tricky exercise. Regardless of whether you are a buyer or a seller, and no matter what value you do the transaction at, you will always feel the right value was a little different. In case of startups, this conundrum only compounds itself!
Valuation: More art than science, more so in case of a startup
Valuation, in itself, poses enough procedural and technical challenges that in spite of all the various valuation methodologies, which are technically robust in their own rights, valuation is regarded more of an art, than a science.
In case of a listed or a larger entity with established record of profitability and/or cashflows, especially in cases where comparable industry data is available for benchmarking, the science of valuation plays a prominent role. But, in case of startups there is little, if any, history and a very wide open canvas of what it can grow to be. It is not unexpected to assume that in case of startups as the actual performance of the company will substantially vary from the projected one. Hence, DCF approach, which may be relevant in certain cases, will not hold water in such cases where the degree of certainty of projected cashflows is highly circumspect. Hence, any value ascribed to it might as well be arrived at by rolling the dice. The odds are pretty much the same!
Nevertheless, it cannot be ignored that the biggest test of valuation is common sense. If the valuation methodologies throw up a figure which either defies logic or which sounds too good to be true, it most probably is!
Rule of thumb
As investors move along the learning curve, having invested in numerous startups, they tend to form a feel and hence thumb rule of what kind of valuations DON’T make sense. Of course, with time and euphoria, these rules of thumb also tend to change. This may sound arbitrary and a highly subjective methodology of valuation. Albeit, there is enough empirical evidence to prove that any investment in a startup at a value of higher than the US$ 1m to US$ 2m has a thin statistical chance of making for a good investment for the investor. Hence, the early stage investor will always be wary of investing at a value higher than this range.
Would be useful to always bear in mind another golden rule of valuation of startups: he who has the gold makes the rules! So, it doesn’t matter what the entrepreneur think his business is worth. What the investor thinks as the businesses worth is what matters. After all, a business is worth only as much as what an investor is willing to write a cheque for!
Pre- and post-financing valuations
The pre-investment (a.k.a pre-money) valuation is the value at which the new investor comes into the business. It is the value of the business before the new investment is taken in. As a corollary, the post-investment valuation (a.k.a. post-money) valuation is the value of the business after the new round of funding/investment has come in.
Say, for e.g., a VC fund invests $500k for a 20% stake in a company, then the existing shareholding would amount to being 80% of the company. If 20% is valued at $500k, then the balance 80% would be proportionately valued at $2mn. Thus, the pre-money valuation of the company is $2mn and the post-money valuation is $2.5mn. Instead, if the VC fund had invested $500k for a 25% stake in the company, the pre- and post-money valuations of the company would be $1.5mn and $2mn respectively.
Albeit, it is pertinent to note that the pre- and post-money valuations are both an implied derivative of the amount being invested by the investor and the stake acquired by him against that investment.
Conclusion
From an entrepreneur’s perspective, valuation indeed is important, as it will determine what stake of his/her company will need to be diluted in favour of the investing stakeholders. But, its importance is oft-times over-rated. Its better to have a small pie of a large cake than be saddled with a very large pie of a rather small cake.
Would like to sign off with a small word of advice to all startups. If you have the right investing partner (smart money), focus on ‘value’ rather than valuation! Rather, if you are very confident of your business’ ability to grow, settle for a lower valuation if you have to for the sake of the fund-raising, but ask for milestone-based MSOPs. This will enable you to increase your own value, without compromising that of the investors. Of course, it would not be out of place to mention here: the value of the promoter’s holding is also a misnomer of sorts. In almost all cases, the promoter will be bound by legal restrictions to be able to cash out his position, unless all others have been given an opportunity to exit first.
