Does investing your money in a startup look risky? But then how do venture capitalists and angel investors value these startups? Why are they ready to invest even in pre-revenues startups? Let’s try to find the answers to these questions.
Also, let’s talk about, how Zomato was able to fetch such a high valuation for its IPO even while incurring losses. How Zomato was the one that was successful even after not being able to generate enough cashflows?
To know this, let’s first understand what are some of the important factors that are considered while valuing a startup/ business:
Important factors considered while valuing a startup/business:
- Market attraction: This means how many customers you already have and what is the scale to which you can extend them. The higher, the better. This is also determined by the growth rate of your business and the effectiveness of marketing that you are doing. Marketing + Growth -> increase in the number of customers
- Management/ Founding team: This factor involves the experience, skills diversity, and commitment of the managing members. If the members have the required experience to be able to grow a business and know the functioning of the market, they can steer the startup towards growth. Also, the diversification in skills is important as one might be good in product development but not in marketing, hence skill diversification becomes important.
- Demand and supply: If the number of startups is more in your area of business, then there may be a supply and demand mismatch. This will eventually lead to lesser valuation for your business and vice-versa.
- Growth rate of Industry: The growth rate of the industry in which your company is operating can also help you in gaining valuation. The higher the growth rate of the industry, the higher the valuation.
- Presence of Minimum Viable product: The business can attract huge investments if the startup/ business has an MVP and some early adopters. Further, if the business has a working prototype, and the company is reviewed with the valuation-by-stage method (explained below as method 1), the valuation can be even higher.
- High Margins: If your business has higher margins, it would attract more investment. However, it’s not only the current margins that are looked at here, it’s the potential margins that the business can earn in near future.
After knowing the various factors, let’s see how they are quantified and used in actual valuation:
Ways of valuation:
- Berkus Method: Through this method, the investor envisions the company breaking $20 Mn in the coming 5 years, however, he doesn’t take the market into account. In the process, he assesses 5 aspects of a startup namely:
- Concept (offering basic value with acceptable risk),
- prototype (for reducing technological risk),
- quality management team,
- connections (strategic relationships to reduce competition) and
- launch plan (sales plan and product roll-out)
- Scorecard Valuation Method: Here, the investor compares the startup with an already funded startup. First, he determines the average valuation of these startups in the marketplace. After this, he starts giving weightage to different factors of the targeted startup. In the process, he considers:
- strength of management team,
- size of opportunity,
- product/technology,
- competitive environment,
- marketing,
- need for additional investments and others
- Venture Capital (VC) Method: It’s a 2 step process. Firstly, calculate the terminal value of a business in the harvest year (year in which investor will exit). After this, calculate the pre-money valuation by tracking backward with the expected ROI. The figures needed to value are:
- Projected revenue in harvest yr
- Projected profit margin in harvest yr
- Industry PE(Price: Earning) ratio
- Return on investment
- Investment amount
- Asset-Based Valuation method: It is the easiest way to reach the valuation by the formula:
- (Shareholder’s equity- Preferred equity)/ Total Outstanding shares
- Risk Factor Summation Method: It takes into account even more risks than that covered in the Scorecard Method and Berkus Method. These risks include political risk, international risk, etc
- Cost-to-Duplicate: In this method, the investor assesses the physical assets of the startup. He won’t like to invest more than the market value of assets. However, it fails to account for brand value.
- Combo Platter Method: This method values the startup by using a 3-tier valuation range and tries to consider maximum factors while valuing it.
- Other methods: Discounted cashflow, Liquidation value method, First Chicago method can also be used
So, after studying the various factors and startup valuation methods, in conclusion, we can just say that the list is not exhaustive. Also, any investor can add or subtract the factors according to his need and the sector he is dealing with.
Also, now let’s look at the situation with Zomato with a different lens. If we try to answer the question raised in the beginning about Zomato, it has become clear why it was able to get oversubscribed. The answer is the growth of the company!
Although the company had been running in losses for some time, but the demand for food delivery is going to be on the rise for the next 25 years. This demand leads to better revenue chances for Zomato, and hence, better return on investment to the investors. All this adds up to a better valuation for Zomato!
So while valuing any startup or company, let’s keep in mind that it’s not the current value you are assessing but the future value of the company in which you would like to invest.