How Valuations Work

“What are the best practices to arrive at a good valuation?” is a question that I hear a lot. With young companies, it is the potential and vision that primarily defines the valuation while with mature companies, it is the numbers that drive the valuation.

At the start of 2019, WeWork was valued at $47 Billion, and CEO Adam Neumann was noted for his boundless audacity and lofty goals of wanting to change the world. However, all this changed when WeWork released its S-1 registration for its proposed initial public offering. The vision and numbers didn’t match. Apart from mismanagement, conflict of interests and other concerns, what also stood out was that WeWork was essentially a real estate company valued like a tech company. Over the course of a few weeks, WeWork’s valuation plummeted from $47 Billion to $10 Billion. More recent reports peg the valuation below $8 Billion.

While founders need to look at the big picture and have bold vision statements while starting up, it is also critical for these visions to be grounded in reality. The vision and numbers have to converge at some stage. If not, the market ends up making the correction for companies that are either overvalued or undervalued. Let us take a step back to discuss valuations and how they work.

Estimating Valuations

In early stages, most startups either have a working prototype or minimum viable product (MVP), little or no revenues, and a small lean team. The task of assigning a valuation at this stage is particularly tricky. Most investors first look at these key metrics for validation:

• Is the product or service unique, and does it have a competitive advantage?
• Is there a large untapped market? What is the Total Addressable Market (TAM) that can be captured?
• What complementary abilities and skillsets do the founders bring to the table? Do they have the ability to adapt to change?

Investors then arrive at a valuation range based on current progress and milestones that they believe the startup can achieve in the next 12–24 months.

Different investors focus on investing in companies at different stages. Some investors like Kalaari primarily focus on early-stage, investing at Seed and Series A rounds. These investments are evaluated as potentially high risk, high return opportunities. Other investors focus on growth stages, investing at Series C rounds and beyond which are medium risk, medium return opportunities.

Entrepreneurs need to target investors based on stage and valuation expectations. Hence, having a sense of a realistic valuation for your business is critical while fundraising.

In recent times, industry veterans and second-time founders have raised large rounds at high valuations without having a working product in place. In essence, the startup has skipped the seed round and raised capital at a Series A or Series B valuation range. In these cases, investors are willing to pay a premium based on the track record and are primarily investing in the team’s ability to execute.

Since valuation is an imprecise exercise in the early stages, the convertible note and Simple Agreement for Future Equity(SAFE) methods have gained popularity in India and abroad. Through these methods, investors pump in the capital but don’t value the startup on the current round. Instead, they take equity in the next round at a predetermined discount. This method is generally applied only during seed stages and occasionally during Series A rounds but rarely in stages beyond that.

Estimating valuation for growth stage or established startups is supposed to be more straightforward. Investors look at valuation through different lenses like Discounted Cashflow method(DCF), Comparable or Human capital and market value method. On paper, investors should be able to calculate the market value of the business using tangible metrics and assets, such as revenue, profits, and customers. But most new-age tech startups aren’t profitable even in their growth stages and in some cases, it is difficult to quantify technology assets effectively.

Different sectors also have different valuation multiples. For example, in e-commerce, most valuations are based on historical earnings. A multiplier (typically between 1.5 and 3.5) is applied to the net profit of the business for at least the last twelve months to arrive at the company’s valuation.

For early-stage startup founders, my general advice would be to arrive at a valuation that you can easily justify. A good sweet spot is a middle ground between your base case and the best-case scenario. This gives you enough room for growth for the next stages whether things go according to plan or not.

In contrast to public companies that are valued constantly as people buy and sell stocks, startups are valued only when they raise funds. That valuation is mainly set by one lead investor based on what he or she is willing to pay to get into the deal. Valuations are also dependent on external factors like timing and how the industry or economy is doing.

First mover vs innovative followers

A startup can do everything right, but one of the most crucial factors that contribute to success is getting the timing right. A first mover and innovator in a space may gain significant sales and strategic advantages but large cost disadvantages in terms of customer acquisition. A fast and innovative follower may be able to learn from the first mover and keep customer acquisition costs low but may trail behind when it comes to sales.

A ‘hot’ sector generally sees fierce competition in the early stages with companies approaching the problem from different angles. The end game scenario plays out when a few companies break out from the rest of the pack with a solution that is magnitudes of times better than the competition. These companies are able to raise large funding rounds at high valuations. This is generally followed by consolidation with other smaller players either merging, pivoting, or shutting shop.

Google, the 17th search engine, was competing with Yahoo and other early movers but stood out because its PageRank algorithm was magnitudes of times better than its competitors. The 2015 FoodTech wars in India saw multiple players compete but only a handful such as Zomato, Swiggy and Faasos have survived because they had gained the first-mover advantage and had differentiated offerings.

In public markets, two companies with similar revenues in the same sector can have different valuations. Investors place a premium on factors such as predictability of revenue, quality and trust in the management. This applies to private companies too.

While some customers buy only when products are available at a discount, that mindset gets detrimental if entrepreneurs get stuck on a particular valuation while fundraising. Founders sometimes need their survival instincts to kick in to help them make pragmatic decisions around valuation. Let us look at the best course of action in different scenarios.

Things to consider while fundraising

If your startup has more than twelve months of runway and is growing steadily month-on-month, then you have some leverage to get a high valuation. But even post-term sheet signing, ten to twenty percent of companies don’t close their round for a variety of reasons. When a deal falls apart, companies get put into the difficult position of restarting their fundraise process with a much-reduced runway. So, never get overconfident till the funding round is closed.

Often people are not practical about what leverage they have or don’t have. Do not try to bluff your way while raising capital. Fundraising is not a game of poker, and discrepancies, if any, will often become visible in the due diligence phase.

Key milestones such as revenue, customer acquisition and other key performance metrics need to be thought through carefully. Things backfire when companies suggest very aggressive plans and then they aren’t able to meet targets.

Be honest about what you can achieve. Most investors aren’t investing in current numbers but for the future of the business. The best course of action is to have a systematic approach to fundraising and growth.

Know your numbers, be upfront about your strengths and weaknesses and ensure you articulate your startup’s short term and long term vision to the best of your ability. In many cases, founders don’t ask hard questions or create a sense of urgency. Many founders are afraid to hear a “No” and hence sometimes assume they have heard an implicit “Yes”.

I have come across some entrepreneurs who put in a great deal of effort in polishing their pitch planning every sentence and pause. Don’t get carried away with perfecting your pitch, just ensure that you can communicate well. What investors look for is clarity of thought, conviction and ability to execute.

It is important to have a full grasp of the opportunities and challenges of your business at a very detailed level to build credibility. Don’t be defensive when receiving feedback. Genuine listening is an important skill that shows maturity. Be authentic — you are actually inviting a partner to work with you for the long haul.

You need to confirm that a potential investor actually has an interest in investing and then assess that by the progress in their engagement with you. A meeting doesn’t always equate to strong interest. Ask questions like,

“When do you think I could get a final decision?”

“When do you think I could get a term sheet?”

“What metrics would you like to see to make this deal happen?”

In a hot market, a funding round may also get oversubscribed- the founding team may get more capital on the table than they are ideally looking to raise. A good practice in this scenario is to accept the capital, provided the team isn’t giving away too much equity in the process.

More than expected capital gives the startup a longer runway and also room to experiment with long shots that could have handsome dividends. But be cautious of extremely high valuations as it increases expectations and it can create negative goodwill for the business. Such companies have to show high-growth between rounds to justify their valuation.

Less than six months of runway

When startups have less than six months of runway, they have to quickly make one of these four decisions quickly:

1. Cut your burn to increase the runway.
2. Close a funding round quickly (within 60 days) even if it is at lower than expected valuation.
3. Raise a smaller round or bridge round with existing investors to increase the runway.
4. Do active business development to find strategic investors.

It is human nature to try to delay or avoid decisions when one is in a tough spot. However, the delay often does far more damage than whatever fallout one is trying to avoid. In this case, a bridge round or any of the other options is just a temporary bump but running out of capital and being forced to shut down is a permanent stop. So, ensure you make timely decisions in tough times, stand by them and be honest with yourself and everyone around you.

Also, don’t worry too much if you don’t get your desired valuation at any stage. Focus on growing your business in a sustainable way and the market will reward you your dues when the time is right.

Acknowledging Harshith Mallya, who contributed to this article. Harshith is a Kstart Fellow.

Disclaimer: Views represented in this blog are personal and belong solely to the author and do not represent the views of Kstart or Kalaari.