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White paper on the analysis of High share premium amongst Startups in India

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High share premium is not the basis of a high valuation but the outcome of valid business decisions. This new whitepaper by iSPIRT highlights how share premia is a consequence of valid business decisions, why 56(2)(viib) is only for unaccounted funds and measures to prevent valid companies from being aggrieved by it

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White paper on the analysis of High share premium amongst Startups in India

  1. 1. Executive Summary- Analysis of high share premium amongst startups in India and how valuation methods determine share premium and not vice versa Valuing companies early in the life cycle is difficult, partly because of the absence of operating history and partly because most young firms do not make it through these early stages to success. - Aswath Damodaran Valuation is more an art than a science – this is especially true of startups and early stage companies. Valuations in early stage companies, due to the nascent nature of the startup and the high degree of risk associated with it, are driven primarily by the potential the business possesses, the projections prepared by the management and the path to achieving them. Even professor Aswath Damodaran, a world-renowned expert on valuation states that valuation methods based on cashflows are still useful insofar as they force us to confront the sources of uncertainty, learn more about them and make our best estimates. Thus these valuations cannot be judged on the basis of hindsight as accurately forecasting future events is beyond the realm of human ability. Recasting the factors retrospectively will dramatically alter the valuation of the company and renders the the valuation exercise moot. Even changing the valuation method can drastically alter the valuation of the company, as illustrated in this paper. The paper elaborates upon the thought-process behind an investor’s decision to accept a valuation and the protections put in place by them, which is standard of any investment by angels or venture capital funds. The paper further illustrates with an example of how a high share premium is the outcome of valid and normal business decisions taken by the founders of these startups consisting of: • The valuation • Low share base • Low face or par value Thus a high share premium is not the basis of a high valuation but a consequence of the mathematical function of price determination caused by the above three factors. The paper further discusses the context behind the insertion of Section 56(2)(viib) an analyses the 2012 Indian Budget Memo titled "Measures to Prevent Generation and Circulation of Unaccounted Money”, which stresses that the impugned section was inserted to prevent unaccounted funds being converted via high premiums. In light of this, it states that companies raising funds at a premium from known and accounted sources should not aggrieved by this section and proposes measures to prevent the same. These recommendations include: • Obtaining and furnishing the PAN of investors should be made mandatory for any such investments • Money should only be received through proper banking channels
  2. 2. • Changing the valuation method by the Assessing Officer should be disallowed as the valuation is bound to change if the method is changed • Valuation methodology is to be made at the choice of the assesee and Discounted Cash Flow is a valid valuation methodology should be reiterated • Comparisons of projections to performance is unfair as it vitiates against the data and information present at time of preparation of the report by viewing it retrospectively • High premium is not the reason for a valid valuation report to be disregarded as it is the outcome of a mathematical function derived from normal business decisions
  3. 3. Analysis of high share premium amongst startups in India and how valuation methods determine share premium and not vice versa Abstract: The aim of this whitepaper is to explore how startups are valued by angel investors the data points underpinning any valuation exercise and how a change in those data points or valuation method can drastically alter the enterprise value of any company. It further explains the process of valuation, how the issue price of securities is determined and why a high share premium is not the basis for a high valuation but the outcome of a mathematical function based on valid and legal business decisions taken. The paper further explores the valuation angle from the perspective of section 56(2)(viib) of the Income Tax Act, 1961, the reason for its enactment and how it is affecting startups and their capital raises. Lastly, it proposes measures that can be undertaken so that genuine startup capital raises are not aggrieved by this section whilst the original intent of the same is preserved. Introduction: Valuing companies early in the life cycle is difficult, partly because of the absence of operating history and partly because most young firms do not make it through these early stages to success. - Aswath Damodaran Valuation is more an art than a science – this is especially true of startups and early stage companies. Valuations in early stage companies, due to the nascent nature of the startup and the high degree of risk associated with it, are driven primarily by the potential the business possesses, the projections prepared by the management and the path to achieving them. Historic data and comparables seldom exist due to limited operating history, specialised nature of the business or the high degree of innovation in the business model or IP underpinning the business. Some of the reasons why obtaining an invariable valuation is hard for such startups include: - No operating history - Ongoing development product-market fit - Small or no revenues for the initial years - Profitability sacrificed for growth and scale - Low survival rate - Illiquid investments - No exact comparables available Any such valuation reports prepared and evaluated by trained valuation professionals such as accountants, finance experts or merchant bankers are based on existing data parameters given by the management and assessed by the valuers. These data points are done taking into consideration current market conditions, future changes to operations, competition, risk and various other factors.
  4. 4. As such, these valuations are an opinion expressed on the basis of these factors and cannot be treated as a certificate of assurance. Furthermore, these valuations cannot be judged on the basis of hindsight as accurately forecasting future events is beyond the realm of human ability. Thus recasting the factors retrospectively will dramatically alter the valuation of the company and renders the the valuation exercise moot. Even changing the valuation method can drastically alter the valuation of the company, as illustrated in this paper. These early-stage companies may also have deviations from actual performance as the Company changes its business model or pivots, and thus retrospectively comparing actual performance to projections is unfeasible. Figure 1, created by Professor Aswath Damodaran in his paper – “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges” shows how the earnings vs revenue equation changes for such start-ups as they grow and scale their business. In India, there have been cases of startups having their valuation questioned by the tax authorities on the basis of the premium associated with the issue of securities. The reason for these high premiums are explored further in this paper. Valuation and determination of the issue price of securities For all companies, the issue price of a security is determined by the following formula: Share Issue Price = Enterprise Valuation No of shares issued
  5. 5. Where, • The issue price of a security is the price at which a security is issued to any investor by a company, • The enterprise valuation is the value of the company determined using any appropriate valuation methodology (Discounted Cash flow, dividend distribution, etc) • The number of shares issued represents the share base of the company prior to the proposed investment There are 3 types of issues made on the basis of the issue price: • Issue at face value or par value • Issue at a discount • Issue at a premium Where, • The face or par value of the share is the nominal price of the share, • Shares are issued at a discount when the price paid by an investor is less than the par or face value, ie, Issue Price = Face Value - Discount • Shares are issued at a premium when the price paid by an investor is higher than the par or face value, ie, Issue Price – Face Value + Premium Shares issued at a discount: In India, shares cannot be issued at a discount as per Section 53 of the Company’s Act 2013 except during an issue of sweat equity in the manner stated in Section 54 of the Company’s Act 2013. Shares issued at a premium In India, the shares issued at a premium have come under intense scrutiny with the tax authorities requiring a justification for this high premium. But a high premium is not the justification for a valuation, it’s the outcome of a valuation exercise. A high share premium is the result of 3 factors, all of which are individually valid business decisions taken by a company: • The valuation • Low share base • Low face or par value Valuation: The valuation of a company has been discussed above. In short, it is the value that an investor ascribes to a business prior to making an investment and consists of a variety of factors, both tangible and intangible. Venture Capital funds and angel investors develop their own proprietary valuation methods to properly value start-ups, taking into consideration a multitude of factors encompassing the macro-economic climate to the firm specific risks such as the management team, competition, etc. Generally speaking, the following metrics are closely encapsulated into the valuation of the deal:
  6. 6. 1. Founding team details such as educational qualifications, work experience, core skills 2. Area of operations and business model of the company 3. Market details of the company including addressable market, serviceable addressable market and serviceable obtainable market 4. Revenue or monetisation model 5. Funds invested into growing the business. This includes expenses for: a. Product development b. Market penetration c. Research and development d. Marketing e. Employee expenses f. Technology expenses 6. Investors rights detailed in the definitive agreements Depending on the investor, the weightage given to these factors may change and thus the valuation offered by one investor may not match the valuation given by another investor. Investor Rights: Of the metrics mentioned above, investor rights are especially important as the rights angel and startups investors are significantly different compared to the rights received by other shareholders or investors into public listed companies. These rights cover diverse areas such as exit rights, right to participate in further capital raises, down-round protection, etc. Some of the rights incorporated into such agreements include: 1. Liquidation Preference: - This right entails that the investor will be able to have his/her capital returned in priority to all the other shareholders of the company whenever an exit event occurs 2. Anti-dilution protection: - If the valuation of the company drops in any future round, then the investor will have the right to have his entry valuation adjusted to accommodate such a change. It gets instituted through a variety of mechanisms including changing the conversion ratio of the convertible instrument used for the investment 3. Tag Along rights: - A tag-along right allows the investor to sell their shares on the same terms as the promoters or founders selling their shares to any third party - A full tag right is also instituted when a promoter or founder’s transfer causes a change in control of the company 4. Right to Maintain shareholding: - This right ensures that during any future fund-raising rounds, the investor will have a right to maintain his current shareholding by investing in the future fund raise at the same terms. This right will hold good even if the next round of funding happens via a private placement 5. Exit rights: - All investors invest into startups with an exit horizon delivered via a variety of methods including IPOs, buybacks, trade sale, secondary sales, etc
  7. 7. All these rights are factored into the internal calculus performed by angel and Venture Capital investors and are incorporated into the investment documents prior to the actual investment. Share base: In India, THE COMPANIES (AMENDMENT) ACT, 2015 (REGISTERED NO. DL—(N)04/0007/2003—15) removed the minimum share capital requirements for starting a Company (previously, Rs 1 lakh for private limited Companies). Thus, many entrepreneurs choose to start their companies with a small initial capital base as they choose to get investors on from a very early stage. This is purely a business decision of the company and the management, in compliance with applicable law. Face Value: The authorised capital of a company is the total capital that a company is authorised to issue in the future. It consists of the face or par value of the share multiplied by the number of shares that the company can issue. This face value is usually chosen as a small number to increase the number of shares a company can issue within its authorised capital. Since a large stamp duty needs to be paid for any increase in the authorised capital (amount of fees payable is given in this table) , these early stages companies that need to heavily invest into operations choose to maintain a low face value so that the number of shares they issue can increase without having to increase the authorised share capital. Again, this is purely a business decision of the company and the management, in compliance with applicable law. Thus, a combination of these factors leads to the large premium associated with these shares. Example Valuation exercise Startup A chooses to begin its journey with an initial capital of Rs 1 lakh. The balance sheet after incorporation would be: Particulars Amount (Rs) Particulars Amount (Rs) Share Capital 1,00,000 Fixed Assets 60,000 Cash 40,000 Total 1,00,000 Total 1,00,000 Figure 2 – Financials post incorporation The Founders bootstrap the business through personal loans or further equity until they can attract angel funding. They choose to fund the initial operations with a loan of Rs 2.25 lakhs. Their financials before any funding round would be:
  8. 8. Particulars Amount (Rs) Particulars Amount(Rs) Share Capital 1,00,000 Fixed Assets 60,000 Shares 1,00,000 Cash 15,000 Losses (2,50,000) Loans 2,25,000 Total 75,000 Total 75,000 Figure 3 – Financials before funding Startup A manages to attract angel funding at Rs 1 Crore at a post-money enterprise valuation of Rs 10Cr (arrived at via Discounted Cash Flow) from various angel investors • Share base: 10,000 shares • Face Value: Rs 10 each • Post-Money Enterprise Valuation: Rs 10 Crore • Share Issue Price: 10 Crore/10,000 shares = Rs 10,000 • Share Premium (Issue Price – Face Value) – Rs 9,900 Whereas the book value prior to funding would be determined as follows: Assets – Liabilities Number of shares issued = 75,000 – 2,25,000 10,000 = (Rs 15/ share) Post the Rs 1 crore round of funding, the financials would resemble the following: Particulars Amount (Rs) Particulars Amount (Rs) Share Capital 1,00,10,000 Fixed Assets 60,000 Shares 1,10,000 Cash 99,25,000 Share Premium 99,00,000 Losses (2,50,000) Loans 2,25,000 Total 99,85,000 Total 99,85,000 Figure 4 – Financials Post Funding Thus, Startup A, with a Net Asset Value of negative Rs 15, raised capital at a share premium of Rs 9,900, a difference of 660x! This shows the marked difference a change in valuation method causes as the data points behind each valuation method are different from any other valuation methods.
  9. 9. Choice of valuation method and the impact on valuations As discussed previously, a change in the valuation method or the data points underpinning a valuation can have a marked change on the valuation of any company. In India, section 56(2)(viib) allows the assessee company to choose 2 valuation methods: • Net Asset Value (NAV) • Discounted Cash Flow method (DCF) Between these, the vast majority of startups raising capital choose the DCF method over NAV for the following reasons: • NAV is a purely historic method of valuation as it looks at the value of all the assets as of the date of the valuation and subtracts from it all the liabilities to arrive at the amount of funds a shareholder can receive it the business was liquidated immediately • NAV fails to take into account any future growth or earnings which are instrumental for startups, given their limited operational history and nascent stage • NAV penalises companies in sectors such as technology, biotech or IP-driven enterprises on the basis of their business models since by nature, they are not asset-heavy businesses • The NAV of any early stage company, due to its recent incorporation, lack of revenue and assets, will always be low DCF is an apt valuation method, as described by Aswath Damodaran The value of a young, start-up firm is the present value of the expected cash flows from its operations, though estimates of these expected cash flows may require us to go outside of our normal sources of information which include historical financial statements and the valuation of comparable firms. But he caveats this by adding: While these approaches require us to estimate inputs that are often difficult to nail down, they are still useful insofar as they force us to confront the sources of uncertainty, learn more about them and make our best estimates. Even the esteemed valuation professionals such as him agree that these valuations are difficult and require the use of best estimates. But comparing these estimates to actual performance and taxing the difference goes against the spirit of the estimates and the basis of this valuation method. Section 56(2)(viib) – reason for enactment and interplay with current developments in India A previous whitepaper titled “White Paper on Section 56(2)(viib) and Section 68 and its impact on Startups in India” explores section 56(2)(viib) and its genesis in more detail. But to summarise, this section was introduced in 2012 under the heading "Measures to Prevent Generation and Circulation of Unaccounted Money”, which includes a pertinent line about the raison d’etre of the provision and Section 68:
  10. 10. Judicial pronouncements, while recognizing that the pernicious practice of conversion of unaccounted money through masquerade of investment in the share capital of a company needs to be prevented Thus, the stated reasons for these measures are as follows: • There existed a means to convert unaccounted money by investing it at a premium • This premium was not necessarily backed by a valuation • Then extant methods to tackle this were unfruitful, leading to this legislation Thus the stated intent is to prevent the laundering of funds as high premium without any valuation to justify said premium. In this regard, the key would be to establish that the funds are from accounted sources, received from proper channels and not to question premium given from known fund sources and justified by proper and valid valuation reports. Recommended best practises: The best practises recommended for ensuring that fund raised from known sources and from tax-paid money is not aggrieved by measures to prevent the flow of unaccounted funds would be as follows: • Obtaining and furnishing the PAN of investors should be made mandatory for any such investments • Money should only be received through proper banking channels • Changing the valuation method by the Assessing Officer should be disallowed as the valuation is bound to change if the method is changed • Valuation methodology is to be made at the choice of the assesee and Discounted Cash Flow is a valid valuation methodology should be reiterated • Comparisons of projections to performance is unfair as it vitiates against the data and information present at time of preparation of the report by viewing it retrospectively • High premium is not the reason for a valid valuation report to be disregarded as it is the outcome of a mathematical function derived from normal business decisions Conclusion: Startup valuations are an art more than a science and the value one investor sees in such a business will vary compared to the value ascribed by another investor. These values are also idiosyncratic as they depend on a variety of intangible and unquantifiable factors. The inherent risk in such investments also colours the chance of success of such ventures. However, angel investing is a vital step for any vibrant startup ecosystem as such investments represent the first capital coming into such companies, through which the business can be built up. In the government’s fight against illegal funds, genuine companies raising funds from known sources in compliance with all applicable laws should not end up as collateral damage.
  11. 11. About the Author: • This paper has been authored by Siddarth Pai, Policy Expert Council Members, iSPIRT Foundation and Founding Partner at 3one4 Capital, an early stage SEBI registered Venture Capital Fund based in Bangalore • Inputs from Mr T.V. Mohandas Pai, Nakul Saxena of Ispirt, and Pranav Pai from 3one4 Capital. Citations: • “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges” by Aswath Damodaran • “Investment Valuation - 3rd Edition - Chapter 23 - VALUING YOUNG OR START-UP FIRMS” by Aswath Damodaran

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