Art vs science: How to strike the right balance to correctly value a startup

March 4, 2020 1:11 PM

Traditional companies are easier to value simply because they tend to have physical assets, there is relevant market data stretching back decades and they are more easily understood.

Steady and robust growth is usually a better long-term investment than a red-hot prospect growing insanely fast.
  • By Dilipkumar Khandelwal

How exactly do you arrive at a valuation for a startup? It’s the question investors are most frequently asked. It’s tricky because the answer – especially in the digital space – is based on intuition and experience as much as on numbers and projections. What complicates matters further is the digital business’ lack of physical assets. Instead, what you need is a deep understanding of the business, the market, the customers, the need for the products or services – these are relevant valuation drivers. But how much weightage you assign to each can also be subjective. When done properly, however, the valuation makes sense.

When it comes to digital startups, history too weighs in. The boom in such companies at the start of the century and their subsequent collapse, wiping out many, always make the bet seem risky. Traditional companies are easier to value simply because they tend to have physical assets, there is relevant market data stretching back decades and they are more easily understood. However, familiarising yourself with the market forces, the sector, the demand-supply gap, recent investments and exits, and – this critical – the entrepreneur’s passion usually lead you to the right decision.

Look ahead to look backwards

Some crystal ball gazing is required. Think about what the industry will look like five years from now and then another five years later. Will the growth sustain? Or are you likely to encounter uncertainty and moderation in the expansion? Take into account current performance, customer penetration and erosion, revenues, operating margins, etc. Understand how the startup makes money. The digital landscape is littered with corpses of startups who knew how to build products but couldn’t find ways to monetise them. Brilliance is not the same as business success.

What does the market look like?

How successful has the business been in signing up potential clients? A high strike rate indicates that the startup has identified a market need and is getting the offering right. This is a good time to ask for a revenue forecast too. A comfortable revenue scenario might require the business to convert non-paying customers into paying ones – not always the easiest thing to achieve in the digital space. So, ensure that the forecast is realistic.

Also read: Trouble for Flipkart continues as NCLAT issues probe for alleged abuse of dominant market position

Steady and robust growth is usually a better long-term investment than a red-hot prospect growing insanely fast now but likely to flame out in equally spectacular fashion later. Get a handle, therefore, on fixed and variable costs, industry characteristics and the rate of capital burn. 

Founders with fire

This is perhaps the most critical parameter. A searing, unshakeable belief in the product/service is a must. Successful entrepreneurs know how they are creating value by delivering solutions that are the best for the market. What you also want to see is the ability to deal with disappointments, to bounce back from setbacks (they’re inevitable) and the drive to keep going even in the toughest times.

Also, and especially with digital startups, investors look for someone willing to invest their own money in the business. These entrepreneurs are the ones who believe enough in their business to take on the risk. What else does an investor look for?

  • The management team: Entrepreneurs and a team with a successful entrepreneurial track record are prized. Past success shows calibre and market acceptance.
  • Traction: A functioning product that customers are picking up shows that the business has value. Investors are likely to pay a premium for it.
  • The negatives: A poorly-performing sector with low margins or a high rate of commoditisation are turnoffs. As is a cluttered competitor landscape with little differentiation.

When investors are conducting the due diligence of a startup, they are essentially trying to ascertain the likely size of their exit. A judgment is then made on how much to invest. Lastly, let’s not forget the company’s moral compass. You might ask what that has to do with a digital startup’s valuation. Actually, the company’s culture and commitment to ethics are essential to its success. Most executives will tell you that these factors influence performance and eventually the firm’s value. They are even more make or break in a young company. As you can see, while there is a lot of ‘science’ involved in the valuation process it is as dependent on various intangibles. Getting the balance between the two right is the key.

Dilipkumar Khandelwal is the Managing Director of Deutsche Bank. Views expressed are the author’s own.

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