The science and art of Startup Valuations

1. Startup Valuations: The Science and Art of.. KSCAA 28th Annual Conference 5th March 2016 Anjana Vivek beanie@venturebean.com

2. VentureBean Consulting Private Limited Valuation: Questions ’to trigger thinking’ Valuation: Methods Valuation: Process Valuation: Focus Startup Valuation: Summary Agenda 2 2

3. VentureBean Consulting Private Limited 3 Questions.. . questions.. What do you think of when you hear the word valuation for a business? Do you think it is related to • Sales • Cost • Profit • Cash flow • Combination of above • Other factor?

4. VentureBean Consulting Private Limited 4 • Does value depend on whether one wants to sell a company, to buy a minority stake or to buy the entire company? • Will a strategic investor value a company differently from a financial investor? • How can a company which is continually losing money have any value? Questions.. . questions..

5. VentureBean Consulting Private Limited 5 • Why did ecommerce company valuations in India Zip and Zoom? Are these heading for a slowdown now? • Will all companies lose in value in these volatile times or will some still Zoom in Valuation? If so, which ones will grow and be sustainable? Questions.. . questions..

6. VentureBean Consulting Private Limited 6 Some different ways to value • Cost vs. Market Value • Historical vs. Replacement • Differs depending on need of person doing valuation – buyer, seller, employee, banker, insurance company

7. VentureBean Consulting Private Limited 7 Value to buyer • Valued because of expected return on investment over some period of time; i.e. valued because of the future expectation • Return may be in cash or in kind, tangible or intangible, or a combination of these

9. VentureBean Consulting Private Limited 9 Valuation methods These can be broadly classified into: • Cost based • Income based • Market based

10. VentureBean Consulting Private Limited 10 Valuation methods • Different experts have different classifications of the various methods of valuation • Within these methods, there are sub-methods • Sometimes the methods overlap

11. VentureBean Consulting Private Limited 11 Cost based methods There are different ways of arriving at cost: • Book value • Replacement value • Liquidation value NOTE These methods could become relevant when one is considering the accounting, legal and tax impacts of valuation, for eg. – in deals related to M&As, JVs and partnerships etc.. – in cross-border transactions, depending on countries involved

12. VentureBean Consulting Private Limited 12 Income Based methods • Earnings capitalisation method or profit earning capacity value method • Discounted cash flow method (DCF)

13. VentureBean Consulting Private Limited 13 INCOME: Earnings capitalisation method • Also known as Profit earnings capacity value (PECV) • Value determined by capitalising earnings at a rate considered suitable • Assumed that the underlying value driver of the company is its future earnings potential • Suitable for fairly established business having predictable revenue and cost models • For example – assume that Company Profittee Limited is earning post tax profit of Rs. 5 crores and we would like to capitalize this at 10%. – The value of the Profittee Limited under this method is equal to Rs. (5/10%) crores, ie Rs. 50 crores.

14. VentureBean Consulting Private Limited 14      nt t t t r CF Value 1 )1( • CF = cash flow • t = the year and • r = discount rate i.e. the cash flow for each year from year 1 to year n (which is the time period under consideration) is discounted to arrive at the present value of future cash flows from year 1 to n INCOME: Discounted cash flow

15. VentureBean Consulting Private Limited 15 • Discounted cash flow is based on expected cash flow and discount rates • Sometimes it is difficult to get a reliable estimate for the future and the valuation model may need modification, for example in the illustration below: INCOME: Discounted cash flow Value: Phase 1 Discounted Value: Phase 2 Terminal Value Figure: Net present value NPV of Enterprise Discounted Discounted

16. VentureBean Consulting Private Limited 16 Market Based Methods VALUATION

17. VentureBean Consulting Private Limited 17 Market based method • Also known as relative method • Assumption is that other firms in industry are comparable to firm being valued • Standard parameters used like multiples of revenue, EBIDTA, PAT, book value, • Other indicative parameters such as revenue, revenue per user, net margin per user etc. • Adjustments made for variances from standard firms or deals in the recent past, these can be negative or positive; i.e. premiums and discounts are assigned

18. VentureBean Consulting Private Limited 18 Exercise in Valuation - I Plantation Co. Garden Co. Park Co. Enterprise value/sales 1.4 1.1 1.1 Enterprise value/EBITDA 17.0 15.0 19.0 Enterprise value/free cash flows 20 26 26 Meadows Co. Sales Rs. 200 crores EBIDTA Rs. 14 crores Free cash flow Rs. 10 crores How would you value Meadows Co. based on the market/industry information provided?

19. VentureBean Consulting Private Limited 19 Plantation Co. Garden Co. Park Co. Average Enterprise value/sales 1.4 1.1 1.1 1.2 Enterprise value/EBITDA 17.0 15.0 19.0 17.0 Enterprise value/free cash flows 20.0 26.0 26.0 24.0 Application to Meadows Co. Average Value Sales Rs. 200 crores 1.2 Rs. 240 crores EBIDTA Rs. 14 crores 17.0 Rs. 238 crores Free cash flow Rs. 10 crores 24.0 Rs. 240 crores Exercise in Valuation – I: Possible Solution

20. VentureBean Consulting Private Limited 20 Papers Co Docs Co. Prints Co. Enterprise value/sales 2.6 1.9 0.9 Enterprise value/EBITDA 10.0 21.0 4.0 Enterprise value/free cash flows 21.0 30.0 24.0 Application to PenPencil Co. Sales Rs. 300 crores EBIDTA Rs. 15 crores Free cash flow Rs. 7.5 crores Exercise in Valuation - II How would you value PenPencil Co. based on the market/industry information provided?

21. VentureBean Consulting Private Limited 21 Papers Co Docs Co. Prints Co. Average Enterprise value/sales 2.6 1.9 0.9 1.8 Enterprise value/EBITDA 10.0 21.0 4.0 11.7 Enterprise value/free cash flows 21.0 30.0 24.0 25.0 Application to PenPencilCo. Average Value Sales Rs. 300 crores 1.8 Rs. 540 crores EBIDTA Rs. 15 crores 11.7 Rs. 175.5 crores Free cash flow Rs. 7.5 crores 25.0 Rs. 187.5 crores As there is a wide value range, the application of the relative multiples does not look appropriate in this case. What are your thoughts on this? Exercise in Valuation – II: Possible Solution

22. VentureBean Consulting Private Limited 22 • Simple and easy to use • Useful when data of comparable firms and assets are available • Useful when information about recent deals are available Limitations • Difficulty in getting data, particularly for unlisted companies • Easy to misuse • Selection of comparable can be subjective • Errors in comparable firms get factored into valuation model Market based method

24. VentureBean Consulting Private Limited Valuation Based on • Tangibles and Intangibles • Data and Assumptions • Subjectivity and Objectivity 24

25. VentureBean Consulting Private Limited Valuation • At idea and early stage there is limited data, more subjectivity; higher weightage given to – Team – Potential market – Competitive scenario • At next phase, more weightage is given to – Customer traction – Pipeline – Past record of conversion from pipeline etc. – Immediate past performance – Business and financial model 25

26. VentureBean Consulting Private Limited Valuation • Many methods of computation are there, including but not limited to – Multiples of revenue, EBIDTA, user base, etc – Multiples of industry specific value drivers, e.g. GMV (Gross Merchandise Value), revenue per user, net margin per user – Cash flow based, discounted – Exit valuation expected • Financial forecasts are the starting point and also required from a regulatory perspective. They are also a key point in the due diligence review, prior to investment • Other statutory, accounting and tax implications are to be factored in while arriving at valuation and deal cash flows 26

27. VentureBean Consulting Private Limited Valuation Driven by: • Markets: Flavor of season, competitive scenario, industry trends • Team: At helm plus advisors/mentors/board • Cash burn: Or cash needed, look at scenarios of minimum bootstrap and best case • Percentage sharing: Equity promoter is willing to let go 27

28. VentureBean Consulting Private Limited Valuation Driven by: • Unbundling of deal issues, such as – Board Membership – Decision making powers – Payment/salary to founders – Assistance in administrative matters (eg. Incubation) – Contribution to execution and participation in key activities such as sales, partner tie-ups – Liquidation preference – Exit clauses • Negotiation and taking control of the situation 28

29. VentureBean Consulting Private Limited Valuation • Deals can sometimes be structured to accommodate valuation perceptions – For eg. linking to future performance – This could become an area of concern when there is a possibility of a “down round” when new investors come into the picture • For more on valuation: detailed class notes at http://www.slideshare.net/anjanavivek/valuation- basics (from set of the Top 4% & 5% viewed on SlideShare in 2013, 2014 respt.) 29

30. VentureBean Consulting Private Limited 30 Valuation: Points to be factored Valuation is calculated based on a financial model. The following are also to be considered and factored while preparing the business model and funding plan: • Nature of transaction i.e investment, divestment, M&A , JV or partnership etc. • Whether 1st round or later round of investment • Whether angel investor or VC or strategic investor • Whether family and friends or other • Amount of money required • Stage of company - early stage, mezzanine stage (pre-IPO), later stage (IPO) • Value add by investor

31. VentureBean Consulting Private Limited 31 Valuation: Points to be factored • Key management: Performance, expertise, team diversity and capability etc. • Project, product, USP • Industry scenario, global and local • Country scenario • Market, Total addressable market, opportunity, growth expected • Competitive landscape, barriers to competition • Risks and risk mitigation measures

32. VentureBean Consulting Private Limited 32 Valuation: Points to be factored • Historical performance • Future projections, pipeline • Quality of revenue; historical, and pipeline • Assets, tangible and intangible • Liabilities in financial statements, potential liabilities and off Balance Sheet items • Cash flows expected and tracked alongside revenues expected

33. VentureBean Consulting Private Limited 33 Process of valuation • Use more than one model • Identify current market models relevant to venture • Have a rationale for the models used • Plan long term not short haul • Look at alternate scenarios • Discount for risks, assign probabilities • Arrive at range • Identify deal issues (breaker/maker) for negotiation • Practice before negotiating A valuation range is preferable to a single number

35. VentureBean Consulting Private Limited 35 Valuation : Startup At very early stage it is often a function of: • Amount of cash burn (with different scenarios of bootstrap and adequate funding) • Stake promoter is willing to give up

36. VentureBean Consulting Private Limited 36 Valuation : Startup Examples Names/data changed to maintain confidentiality.. Mentoring: • 1. Edtech Co. 1 year old – Terms: month one meeting (half day), Focus on growth strategy and advisory services for leadership team: 2% equity • 2. Food tech idea stage – Terms: month 2 meetings (2 hour), mentoring on growth strategy, funding strategy and help in fund raising: 5% equity plus 1 % success fee of funds raised • Statutory and tax issues to be addressed while equity is given Incubation by Tech company: • 3. Idea stage: (i) Rs.50 lakhs was committed for 1st year, to be drawn on need basis (ii) Admin/accounting etc. support to be provided (iii) basic sustenance monthly fee of Rs.20,000 per month agreed to for each of 2 founders: 48% equity with Tech Company and balance equally by two founders

37. VentureBean Consulting Private Limited 37 Valuation: Startup Examples 4. Investment in media/entertainment company (numbers changed to maintain confidentiality) • HewS closed $10 million valuation from InvestorA • Reading press reports, Investor 2 wanted to participate and asked the promoters to suggest a valuation • HewS Team and InvestorA decided at random: 20% increase in 1 week, leading to valuation of $12 million; • On flight as InvestorA travelled to meet Investor2, he decided he would not just be a messenger, he would value add, so he decided to up valuation to $18 m • During negotiations, Investor2 gave final offer of $15 m • Thus in about 10 days the company valuation went up by 50%, from $10 m to $15 m • Founders ended up with more money than they had planned for and had to think of ways to spend this!

38. VentureBean Consulting Private Limited 38 Valuation: Startup Examples Names/data changed to maintain confidentiality.. Service business: Value add measures: • 5. Two year co. – Rebranded, reclassified domain, pre-funding; on advise that revenue multiple would go up from 3 to 5. • 6. – Three year co. – Changed business model to increasing outsourcing of some service delivery aspects. Cost of inputs increased, gross margins reduced, however operational efficiency increased, net profit margins increased and valuation multiples; i.e. revenue and PBT multiples increased. Investor negotiation: • 7. Early stage idea: Jim had high technical knowledge, limited financial knowledge. Investor Z convinced Jim that he could partner and grow the company to high value in 3 years and negotiated for half the business. Jim got into this without understanding how shares could get further diluted in later rounds of funding. At the end, Jim was left with less than 10% of the company he started, however valuation was high.

39. VentureBean Consulting Private Limited 39 Valuation: Startup to Exit.. Think thru

40. VentureBean Consulting Private Limited 40 Valuation: Dynamic Ecosystem Ref: Economic Times: Feb 29, 2016: Flipkart’s valuation markdown: Billions gone in a flash ReadMore@:http://economictimes.indiatimes.com/articleshow/51182907.cms?from=mdr &utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

41. VentureBean Consulting Private Limited Valuation: Impacted by Quality .. • FOCUS on Quality not just on Quantity … • Illustrative parameter: Revenue Quality – Sales Quantity – Quality of revenue - in terms of product/service/vertical/location etc. – Customer segments addressed – Average revenue per employee – Number of customers, number of high value customers – New customers added – Customers lost – Pipeline customers • Customer acquisition strategy 41

43. VentureBean Consulting Private Limited In Summary • Build a Financial Model that is consistent, capture elements of business model; address deal rationale • Look at different valuation models; arrive at a value range • Prepare for negotiation, identify deal issues, possible negotiation strategies • Caution: Look out for concern issues, hidden agendas; evaluate on value-based parameters including but not limited to fund source, governance, ethics and reputation • Keep an eye on the law and statutory regulations; these also impact valuation and deal negotiation • Plan for advisors/CAs/lawyers, due diligence costs and other deal related costs which will add to the price paid or reduce the price received for any transaction • Plan for long term impact of decisions on valuation 43

44. VentureBean Consulting Private Limited Thank you 44 Reference: VentureBean K.Hub (Knowledge Hub) For teaching notes, articles and more on finance, valuation, business models, leadership and more.. • www.slideshare.net/anjanavivek • https://twitter.com/VentureBean • http://www.linkedin.com/company/venturebean- consulting-private-limited • https://www.facebook.com/pages/VentureBean- Consulting-Private-Limited/387846908091034