A Quarterly Newsletter from UAE and Oman

VOL 20 ISSUE 4 October 2018

Valuing a startup

“The secret of getting ahead, is getting started.”
– Mark Twain

Over the past few years, the words ‘Startup’ and ‘Entrepreneurship’ have been used with increasing frequency, describing companies having either disruptive technology, an innovative e-commerce platform, or a unique idea having the potential to change the way business is done. Whilst in the past, economies were primarily driven by natural resources and its processing, with advancement in technology, societies and economies with better intellectual capital and skilled manpower have prospered at a faster pace.

One of the key attributes of any start-up or a youngcompany is its growth potential. Graham Paul, head of Y Combinator Accelerator, a seed funding provider for start-ups, states that, “A startup is a company designed to scale very quickly. It is this focus on growth unconstrained by geography which differentiates startups from small businesses”.

The Middle-East is witnessing a shift from petro-dollars to technology startups, with Dubai being at the forefront of embracing this shift. Over the past few years, there has been an increased dynamism in the start-up arena, with an inflow of resources from across the globe. With the government’s increased focus on developing a start-up ecosystem, along with talent and resources from across the globe coming to the region, the local economy is expected to transform from an oil-based to a knowledge-based economy.

To achieve its true potential, start-ups would require to invest in people, technology, product development, distribution channels etc. Whilst the initial investment in start-ups are usually in the form of equity from its founders, as these young companies scale up operations, fresh capital becomes essential to sustain the growth trajectory. Given the uncertainties and the risks involved in start-ups, debt is an expensive instrument towards raising funds and can also prove extremely difficult to obtain. Venture capital, crowd funding, and peer-to-peer lending, are few of the popular options available to entrepreneurs looking for growth equity.

Given the importance of obtaining such capital from investors, valuing start-ups assumes an important role in the process of fund raising. Other reasons necessitating valuing young companies might include issuance of ESOPs and stock grants to key management executives, or on exit of any of the promoters.

Challenges in Valuing Startups

Deriving a valuation for a young company, which may be in the ideation phase or with limited history, has its own challenges and requires expertise to adapt and modify the widely-accepted valuation methodologies to suit the specific needs of young companies. Some of the challenges involved in deriving an intrinsic valuation of a young company using the Discounted Cash Flow (DCF) method include:

  1. Estimating cash flows from assets:

    A start-up generally does not have existing assets generating cash flows. Even if it does, it would in all likelihood be predominantly generating negative or zero cash flows. Generally, whilst a company’s value is primarily dependent on future cash flows from growth assets, in an intrinsic valuation, reinvestment rate and return on that reinvestment also drives the enterprise value. However, for a young company, the product or service is typically in the ideation or developmental phase. Consequently, the market, product pricing, and others specifics to attach numbers to the growth asset might not be available.

    Therefore, projecting cash flows over several years becomes a crucial and challenging exercise in deriving the value of a start-up. The profile of the promoters, vision of the management, the capability of the operations team, the quality of the products and its probable market and pricing are few of the factors that are considered while preparing projections.

  2. Ascertaining the risk in the cash flows:

    Given the limited or no history, ascertaining the riskiness in the projected cash flows that is likely to be generated by the young companies is a major challenge for a valuer. The risk, which has to be strictly forward looking, requires appropriate adjustments to capture the total risk involved in the cash flow generated by a young company.

    Further, as any young company evolves, the risk profile of the equity investors in the company (undiversified to diversified investors) changes, having an impact on the beta (systemic market risk) of the company. Additionally, its capital structure would change, resulting in a varying debt to equity ratio over the projected period. Changes in beta and debt to equity ratio would consequently have an impact on the discount rate reflecting the risk in a young company. The valuer would require to accommodate for these probable changes while valuing a young company.

  3. Determining the time to maturity:

    During the initial years of operations, young companies typically register considerably high growth rates, compared to the average growth of the overall market.

    However, it is difficult to ascertain the length of this highgrowth period, the time potentially taken to achieve stable cash flows, or achieve similar growth rates as the overall market. One needs to take into consideration such trends in growth across similar start-ups (subject to availability of data) towards making suitable amendments to the financial projections while valuing young companies.

  4. The probability of survival

    Though start-ups are vital for innovation, job creation and dynamism in any economy, one should also be aware and cognizant of the risks involved. Based on a report published by Harvard Business School, 50% of the US start-ups fail after 5 years of its setup, while 70% of them fail after 10 years of their setup, while certain studies quote failure rates as high as 90%.

    The success rates are not very encouraging for other economies as well. For instance, in India, which is relatively new compared to the US in terms of recorded statistics for start-ups, experts suggest 70%-80% of them will fail. Further, a 2016 study by the Organisation for Economic Co-operation and Development (OECD) found that the survival rate in the UAE manufacturing sector was 83% after year one, falling to 69% after two years, and 55% after three years, while the figures were slightly lower for the service sector, at around 80%, 70%, and 50% respectively. Consequently, considering an appropriate success/ failure rate forms an integral and critical component of valuing start-ups.

    According to Seth Klarman, an American investor and hedge fund manager, “Valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range.” Deriving an intrinsic valuation using the DCF methodology would provide us with a value or a range of values, based on company’s projected cash flows. However, given the challenges discussed above, these cash flows are subject to a myriad of assumptions, and judgement of a valuer which is subjective, and the management of the company. Consequently, on account of the above, many of the industry professionals as a practice value young companies using relative valuation methodologies using trade or transaction multiples. However, a multiple-based valuation has its own share of challenges owing to the following factors:

    • Choosing the appropriate multiple

      As the earnings (profitability) of young companies in the early years are generally negative, and therefore, profit multiples such as EV/EBIT, EV/EBITDA, Price to Earnings cannot be reliably utilised towards deriving a valuation.

      Book value of the capital for young companies would be relatively small, and at times can also be negative, which is not reflective of the true potential of the young company, and this rule out the usage of book multiples. Further, revenue for young companies are also either quite volatile or can be non-existent for companies which are in ideation phase or have just started operations, making the use of revenue-multiples challenging.

    • Ascertaining the peers/ comparable companies:

      For a young company, logically, a reasonable set of comparable peers should be other young companies from the same/ related sectors, having similar risk and return profile, and growth characteristics. However, most young companies are not publicly listed, and consequently, information pertaining to their trade multiples is absent or considerably limited.

      As a proxy, the valuer might consider publicly listed companies as peers based on the nature of business, sectors, etc., however, would then require to make significant downward adjustments in order to be utilised for the purposes of potentially valuing a young-growth company.

      Additionally, one can consider transaction multiples for similar businesses in the recent past. A comprehensive data set would be an ideal benchmark, highlighting transaction prices for similar businesses. However, getting access to such comprehensive data is a significant challenge, especially in the context of the MENA region, wherein most transactions are private deals, which do not require any public disclosures.

      A Venture Capital (VC) approach is another widely practiced method for valuing a startup. In contrast to the intrinsic valuation and relative valuation methodology, the VC approach is negotiation-centric. The value derived using a VC approach depends on three key factors, namely, a current multiple (PE or EV/Sales), forecasted revenue or earnings (typically coinciding with the time when the venture capitalist wants to sell the business or take it public) and, a targeted rate of return.

      Given that the projected revenue or earnings is over a short-term period (of say 3-5 years, as it is difficult to project beyond that), and ignores intermediate items such as reinvestments, the VC approach generally leads to a bargaining game between the two parties, as variables used are highly subjective given the lack of history and the typically high expectations of promoters. Further, the targeted rate of return is a function of two factors, perceived risk in the business and the risk of failure and is typically much higher than the discount rate one would compute under the intrinsic valuation method.

      One of the inconsistencies in the VC method is the use of a current dated sector multiple, which is then applied to the
      projected revenue or earnings expected three-five years down the line, towards deriving the value of the company.

In Conclusion:

Therefore, valuing young companies on the one hand is fraught with challenges, assumptions, expectations of promoters, as well as on the other hand, deriving a fair market value without losing sight of the ‘real value’ of the start-up. Though the VC approach and relative valuation methodologies are simplistic and straight forward, given the relative advantages, using an intrinsic valuation approach potentially provides the valuer with a greater level of control on the valuation derived. Whilst the methodology ultimately adopted is based on the judgement of the valuer, it is imperative that the valuation is consistent in its approach, and suitable adjustments are made in order to suit the specific circumstances of the start-up being valued.

“Price is what you pay, value is what you get.”
– Warren Buffet

(This article is by Mr. Rohit Jain, Assistant Manager Consultant, Management Consultancy Division, Dubai.)