Planning a startup? Know how will a VC evaluate your business

Under the Startup India campaign, there has been a boom in the number of startups in India. The government is taking all necessary steps to promote new startups in the nation. The key factors for a successful startup include a unique idea, hard work and capital. There are various wannabe entrepreneurs who are not able to commercialize their ideas due to the lack of capital. Getting business loan is still a very tedious process. This is where venture capitalists come into the scenario. They are potential investors who invest in potential businesses, mostly startups.

Venture Capitalists generally invest in Startup companies and it is never easy to value a startup company. If it is an existing company then the valuation will be relatively easy based on the brand value, past and present cash flows, assets of the company, company’s management, capital structure, future earnings prospects etc., As all these factors are not available in a startup company because with little or no profits and a bit of uncertain future it is really tricky to value a startup company. The scarcity of historical data and instability add towards the perceived risk of investment. A startup company’s value is largely dictated by the market forces in the industry in which it operates. They generally try to evaluate what will be the worth of this business in the future. There is a saying that startup valuation is more of an art than a science.

Generally, Venture Capitalists follow a method known as the VC Method which is the most used method for valuing startup companies. Investors seek to capitalize on their investment through an exit at some future date in the startup company. They will look at some multiple of their initial investment or will try to achieve a specific internal rate of return based upon the risk they perceive in the venture. They will calculate the net cash flow for the final year in which they are looking to exit the investment which is generally a period of 5 to 7 years. They also use various financial models to predict the future. The future value of the company will be calculated by either Market Multiple Method or Discounted Cash Flow Method.

1) Market Multiple Method: In this approach the VC tries to get an indication of what market is willing to pay for this company that is comparing to like companies. Price to Earnings Ratio (P/E Ratio) is also taken into consideration to calculate the terminal value of the business. Comparisons are made with companies which are in the similar sector or industry, similar revenue growth, similar product/concept etc., and thus will arrive at the valuation of company. The main hitch in this method is it is very hard to find companies with close comparisons, especially in the startup market.  

2) Discounted Cash Flow: This is a very common method to find the future value. The VC will build a model of future cash flow based on the present cash flows. The forecasted future cash flows of the company will be discounted using an expected rate of investment return and will arrive at the present worth of the future cash flows. Generally, Venture Capitalists apply a higher rate to the startups due to the high risk of company failing in generating the expected future cash flows.

The main trouble with this method is the quality of the discounted cash flow which depends on the analyst’s ability to forecast future market conditions and make good assumptions about the long-term growth rates. In most of the cases, projecting sales and earnings beyond a certain point of time becomes a guessing game.

One more method called as development stage valuation approach is used by venture capitalists to quickly come up with a rough-and-ready range of company value. They will have typical thumb rule values and they will apply those values depending upon the stage of the commercial development of the company. The more the company has progressed along the development pathway, the higher its value. In most of the cases the startups will have nothing more than a business plan and hence they are likely to get the lower values. Domestic and foreign investments are helping the businesses grow.

Other import factors that Venture Capitalists consider are the business model of the company, product/service, concept and marketing plans and last but not the least the level of desperation of the entrepreneur looking for money. Another very important factor Venture Capitalists consider is “how risky is the business”. This perceived risk also factors into the expected Rate of Return (ROI). The riskier the business plans, the higher ROI will be. Macroeconomic factors like stock market, interest rates and general overall economic conditions also play some part.

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