There is a lot of confusion among Startups around Fund Raise. Be it around ways to negotiate with investors or decoding the complex framework of Business Valuation or for that matter understanding the complexities around Term Sheet. To answer all these questions and to bring in some clarity to the entire mechanism I decided to take Taxmantra Advantage Webinar Series – The Art of Fundraising Series, where I discuss three important aspect of the the process ie how to get ready for fund raise, tax and legal aspect of fund raising, decoding business valuation for startups with Mr Alok Patnia (Managing Partner, Taxmantra Global).

In this article we shall try to cover the important points of the third session of the Webinar series ie Decoding Business Valuation for Startups (The Entire Webinar can be watched by clicking here) . Over here we discuss issue pertaining to the ways of valuing the company , ways to negotiate valuation with investors, Angel Tax and various things around it.

Q1- Is valuation a science or an art? How to value companies at any different stages?

Ans- Valuation is a mixture of both science or art and hence we need to understand the different stages of the company where you want to raise funds. For example, the valuation for a listed company is easy because it is based on how the company is performing in the quarter to quarter. Once a company starts generating revenues and cash flow, the valuation analysis becomes easier, more technical and robust. Usually investors look for valuations based on comparable transactions within the sector and industry the target company belongs to.

Q2- A query that has heen received – I have just started my company and it is in the pre-revenue stage. What is the best way to valuing my company?

Ans- There is no method of determining the valuation of early-stage companies, as most of the methods look at past performance, current situations and future projections. Excel sheets are good to show but never turns true. Don’t think about valuation at an early stage rather they can opt for issuing of CCD or safe note.

Q3- How to negotiate on valuation with investors?

Ans- Negotiation happens in every aspect of life. A founder should always try to convince the investor about the viability of his idea and earn the faith of the investor to raise more money and only then get the right valuation for his company.

Q4- There are various ways of valuation. Could you please explain those methods in layman’s way?

Ans- There are 5 common business valuation methods that can assist you in determining the value of your business. Those are:-

Asset Valuation:- In this method, the company’s asset including tangible asset and intangible asset are used to determine the value of the company

Historical Earnings Valuation:- A company’s gross income, ability to repay debt and capitalization of cash flow or earnings determine its current value. If your company struggles to bring in enough income to pay bills, its value drops. Conversely, repaying debt quickly and maintaining a positive cash flow improves your company’s value.

Relative Valuation:- In this method the value of the company’s asset is compared with a similar company.

Future Maintainable Earnings Valuation:- Under this method the profitability of the company determines the future value of the company. This method is usually used when future profit will remain stable. To calculate your company’s future maintainable earnings valuation, evaluate its sales, expenses, profits, and gross profits from the past three years. These figures help you predict the future and give your business a value today.

Discount Cash Flow Valuation:- Under this method, the company’s future net cash flows are used and it is discounted to get a present value of the company
However, most valuation, especially in the early stage is finalized after the required discussion between the founders and the investors.

Q5- I am told about angel tax is somehow related to valuation reports. Can you throw some light?

Ans. Angel Tax is referred to section 56 (2) (vii)(b) of the Income Tax Act, issuance of shares by Companies at a premium that exceeds the Fair Market Valuation (FMV) of the shares of the Company. This provision was introduced by the government with an intention to curb black money generation, as share premium was being widely used to generate black money by the use of complex multi-layered routes and inflated shares price of Sham Companies. The law clearly provides that such companies who raise funds at a premium, should have a valuation report from a merchant banker to support such higher valuation based on Discounted Cash Flow (DCF) method of valuation, which is based on future projections and Estimates. So, if it’s a genuine transaction from a genuine investor, backed by proper projections and valuation report, which has been prepared as per the available guidelines on the matter, the Income Tax Department in most of the cases shall only scrutinize such transaction and close the assessment accepting the same and without making any additional demand. There are also some relaxation given to DIPP Registered Startups in this regard. You can contact us or visit our page Global Fund Raise and Due Dilligence if you wish our help in tax and compliance planning during fund raise.

Q6- Is it better to get some revenue before raising funds? I am told this gives you a better valuation.

Ans- There is no rule which says that you must raise fund after generating revenues. Raising funds depends on the need of the company if a company thinks that he needs to raise funds for the growth of the company then he cannot wait for the company to generate some revenue and then go for raising funds. So raising funds always depends on your needs and planning, if you think you need money to grow your business then you can opt for raising funds even at a pre-revenue stage. However, showing some revenue in the books do reflect the viability of the business model and thus might increase the valuation.

Q7- A client asks “I have already raised seed fund and was going for Series A. However, due to the pandemic I am not getting an investor at even the same rate of valuation of seed fund. We might face a cash crunch. I believe I can get an investor at a lesser valuation. What’s your opinion should I devalue for the time being to raise funds and move ahead or keep tight on the valuation?”

Ans- Valuation does not decide the future of the company. If you think that you are facing a cash crunch at must you must seek avenues to cut off your unnecessary expenses. Post this, if you still think you need money then try to raise funds. But at first try with the existing investors as they know you and your business inside out. Don’t think too much about the valuation of the company. The company’s future depends on how you utilize the raised money and not on the valuation report.

India’s startup founders should focus on creating institutions, not just valuations

Valuations alone can never be the parameter on which a business should focus. Valuation should lead to value creation. A business creates value when it is able to generate steady revenue, maintain stable profitability, create an impact, and establishes a model that can be financially viable to last for generations.

Sometime back, I came across a report that India now has more than 35 unicorn startups, around 11 of which were added in 2020 alone. Industry experts have predicted that India will have 100 unicorns by 2025. The targeted focus on unicorns made me wonder how it has now become the parameter of success for startups.
There is this tremendous peer pressure among startups that if they are not raking billions in valuation, their venture is a failure. Ironically, these seemingly successful businesses have been consistently reporting losses, a few of them have also shut down. This is a testament to the fact that valuations alone can never be the parameter on which a business should focus.

Valuation vs Value Creation

It does not mean that valuation is without merit. Problem is that valuation is often confused with value creation. Valuation is heavily dependent on market conditions. Even mathematically, the same company can be valued differently by two different evaluators. It could also have a valuation that is four times in an “in” market as compared to what it would have been in other circumstances.

Hence, it is erratic and a highly misleading metric.

Valuation should lead to value creation. A business creates value when it is able to generate steady revenue, maintain stable profitability, create an impact and establishes a model that can be financially viable to last for generations.

Are startups designed to fail as value creators?

When the objective of a startup is just to make a successful exit or just survive in the herd, it fails as value creators. The journey from being a startup to a matured business is an uphill trek. This is the stage where post-stage startups lose their focus. Since they are not designed to think institutionally, their focus is on exits, they were never built in the first place to move forward.

How do we measure value creation – Capturing the value created

Peter Thiel writes – Even very big businesses can be bad businesses. Creating value is not enough – you also need to capture some of the value you create.

“For example, US airline companies serve millions of passengers and create hundreds of billions of dollars of value each year. But in 2012, when the average airfare each way was $178, the airlines made only 37 cents per passenger trip. Compare them to Google, which creates less value but captures far more. Google brought in $50 billion in 2012 (versus $160 billion for the airlines), but it kept 21 percent of those revenues as profits—more than 100 times the airline industry’s profit margin that year,” Thiel exemplifies.

If a startup only creates value and does not capture it, it would not survive in the long run. As we can see from the above example, revenue or the number of users are not always quality metrics to measure value creation. Net profit, on the other hand, is a far more reliable parameter.

Innovate – do not replicate

The running trend among Indian startups is to replicate existing business models. Replicating an already successful model does not result in mirroring their success too. The next Zuckerberg will not create a social network, Neither will Google be recreated. Be a Maverick – create something disruptive and new that has a niche of its own.

Economies of Scale

At the organization level, we are huge propagators of economies of scale. Each customer that comes your way is a gold mine. With them, they bring their network. A scalable market, combined with a bankable network is what creates a disruptive but sustainable model. Any business that has created a legacy – Apple. Arguably, being the aptest example has taken advantage of the Network Effect. Nearly 70 Percent of Value in Tech is Driven by Network Effects.
Can your startup raise prices and retain your customers?

The litmus test for any business is whether they are able to raise prices without losing their customers. It indicates whether you have something to offer that your competitors do not. A good business must have the ability to capture value. The test of value capture is pricing power. If you’re deathly afraid to raise prices, you do not have what Thiel would refer to as a ‘monopoly’ — you don’t control your market. Disney found that it could raise those prices a lot and the attendance started right up.

Unlocking value propositions

1. Align key decision-makers by creating financial and non-financial ambitions that assimilate short- and long-term value creation
2. Develop a dynamic business model that creates value across multiple time horizons
3. Align KPI dashboards to measure and empower progress towards goals
4. Encourage long term design thinking within your organization

The Future will belong to Camels – Not Unicorns

Gradually, the markets are now making way for Camels. “Camel” startups are reminders that an evolved model exists. These still achieve rapid growth, but balance it with other objectives like managing costs and charging a reasonable price for products or services. The founders of Camel startups understand that building a successful business starts with a strong foundation that is built to last.

Growth is easy to measure. Longevity is not. It is pointless to succumb to valuation mania. User acquisition, revenue, projections are all important but obsessing over it is not the trajectory of creating legacy businesses.