The Startup Valuation Conundrum

The Startup Valuation Conundrum

“We will fund your venture with Rupees five lakhs and we will take twenty five percent shareholding of your start-up company”.

This is what an angel investor offered to one of my friends who operate a start-up business. My friend was very excited and wanted to sign the term-sheet and subsequently the deal.

However, he had some doubts in his mind. Actually he had no clue whether the deal was in his favour or the venture capital firm’s favour. He came to me for advice as I was a financial consultant in a leading consulting firm. This is the major challenge that many founders of a start-up face.

The challenge with start-ups is that they are often cash trapped when they approach an external investor such as angel investors or any other equity investor. So there is a great tendency to take the money at any cost. However, such decisions have far reaching implication and sometimes that becomes the main cause of failure. Here are a few advices regarding valuation of start-up.

  • 1.Understand the underlying implications of an offer
    If you have an offer of twenty five percentage of share against Rupees five lakhs, this means the value of your company is only Rupees twenty lakhs. Now if you have invested more than twenty five lakhs already, there is a devaluation of your existing shares. If you are still going ahead with this offer and your company becomes profitable, the external investors will reap the maximum profit. You have to decide whether such deals are worth considering. Remember you have put your hard earned money and sweat in your venture and you have made it is profitable. Additionally, if there are other investors are they ready to accept this devaluation.
  • 2.Valuation is a science as much as it is an art
    The valuation of a company is primarily based on its potential to generate profits in the future. As future is still unknown, so the value of a company can only be estimated with some error. For a stable company with a sizable market share this estimate can be done with certain degree of accuracy. However, for a start-up with an innovative product or service, estimation becomes extremely difficult. This is because many a time the customers of such start-ups are not properly known and accordingly how customers will grow is also difficult to estimate. Valuation of such companies entails some ingenuity in estimating their future.
    However, there are certain guiding principles in arriving at an estimate
    • a.Customers:if the company is able to demonstrate that there are sizable users or customers of its product or service that indicates the company will sustain in the near future for some time. How many users are required depends upon the product or service and its cost structure.
    • b.Revenue:The other major indicator is whether the users are paying for the product or service. If the company is able to generate revenue which is growing that is another major indicator of its sustenance.

The last word

Here is a word of caution that these are only indicators and they are not conclusive evidence. A deeper analysis of these parameters will result in a better estimate. There are other parameters such as reputation of the founders or who all are supporting this company and their brand equity.

As you might observe these are softer elements and often difficult to put a number against them. It highlights the creative aspect of valuation. In conclusion valuation of start-ups will remain a challenge due to its dynamic nature.

Valuation of start-ups requires some creative thinking to develop a method to value. It is good to take professional advice for valuation of such start-ups. At least two views should be considered. Normally finance professionals are conservative in their estimates where as legal professionals are aggressive in their estimate. Both the views can give you a perspective on the value of your start-up.

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