Valuing a start up

Assessing the value of a start up is one of the most difficult things to do. Investors and investment bankers may like to give the impression that there is a method to it but the truth is that valuating an early stage company is an imprecise science, that depends on a number of factors some of which have little to do with the intrinsic value of your company and more to do with the environment.

So what do VC’s look at while valuing a company. Most investors give you similar answers –

Size of potential market – Generally the larger the better

Quality of the management team - passionate, broad based management teams with complementary skills and domain expertise preferred

Business model – Who pays and for what? How much will they pay? How scalable is the model? Does head count need to scale proportionately with revenue?

Competitive landscape – it is good to be first mover or at least early mover, however if it involves the creation of a new category or market or a radically new consumer habit then it can be risky. It’s nice if customers are used to currently spending money for the same purpose and your offering solves the problem better and you propose to earn revenue from existing spend budgets. It’s also good if this is a proven business elsewhere in the world.

Stage of company – the earlier the company in its life cycle the more risky it is however an investment in an early stage company can yield massive upside to the investors if it goes on to succeed. In spite of the fact that we were probably overpriced in our first round of fund raising, our investors earned a return of slightly under thirty times over a seven year period.

Quality of offering – This a tricky one. How good is the offering? Will it get traction among customers?

Cost structures and potential margins – How large are the margins likely to be when the business scales up? Will margins increase with scale - does the business have operating leverage?

Market structures and market power - Is there likely to be excessive dependence on a few customers? Can the business build up massive dependency for its services among its customers? Will there be switching costs for customers? Does the business build defensible intellectual property? Will there be barriers to entry for competition in the future?

Basically all these are surrogates by which investors can get some sense of potential return and risk – a peek into the future.

Yet there are external factors which will finally influence whether or not a VC will invest in a particular company and if so at what valuation.

At Naukri, in April 2000, we raised our first round of venture funding at a valuation of around Rs. 44 crores - we had achieved sales revenue of Rs. 36 lakhs in the year gone by and. Sounds insane – well it happened. It was a bubble investment – dotcoms were flavor of the month, investors were competing to give us money (we had two offers on the table and we had spoken to only four investors), the Internet was expected to change the world and everyone was going to get very rich very fast. Six months later as it became apparent that the bottom had dropped out of the dotcom market the company would probably have been valued at around Rs. 2 crores even though revenue was going to more than double over the previous year.

Most investors will deny it but there is some kind of herd mentality among many investors. They compete with each other and they talk to each other. So if one investor makes a certain kind of investment that looks like a smart thing to have done it spurs others on to make investments in similar companies. When dotcoms were in fashion in the late nineties everyone wanted to invest in the internet sector. The ensuing competition resulted in a de facto auction and pushed valuations sky high. And when investors decided that they wouldn’t touch dotcoms with a barge pole, valuations were in the basement for a long long time.

Bubble investments followed by a situation where companies were left with no hope of a second round, subsequent tranches were held back, they were merged, promoters were sacked and replaced by professionals - many simply shut shop. All in all it there was a lot of pain for everyone. Yet the intrinsic worth of the companies had not changed much from the time they received their first round investment till the time they were forced to shut shop.

Irrational exuberance followed by irrational pessimism.

Just as beauty is in the eye of the beholder, valuation is in the eye of the investor.

Bootstrap before looking for funding

My September column in Mint.

Over the last several years many aspiring entrepreneurs have met me for advice – be it at business schools, through TIE, at conferences, at business plan contests or by simply sending me a mail and asking for time. Almost all of them have had an idea, a half written business plan – for which they were exploring the possibility of raising capital. Most believe that without committed funding by a venture capitalist they cannot start or will not succeed. Most struggling entrepreneurs would believe that it’s great to raise venture capital at the start – but is it really?

While many successful companies did raise venture capital early in their life cycle, yet there are many more that did not – Microsoft, HP, Dell are three such examples. Closer home Infosys, HCL and Reliance and many other first generation successes were bootstrapped and built the hard way. The fact is that most successful companies and most successful entrepreneurs reached where they have without raising venture capital.

In the company where I work – we managed to get external funding only after we had bootstrapped for ten years.We were delighted to raise capital when we did. However in hindsight, it was the bootstrapping experience that taught us valuable lessons that saw us through the later years.

There are many learnings you get by bootstrapping.

First bootstrapping is a test of commitment – if you are really committed to your idea you will muster up the courage to quit your salaried job, put in whatever little capital you have or can raise from friends and relatives, tighten your belt and somehow begin to execute your idea. If you aren’t willing to bootstrap then question your entrepreneurial motivation. VC’s understand this and they prefer to invest behind good teams that are bootstrapping rather than behind professional managers who are still in secure jobs but have a nifty powerpoint presentation.

Bootstrapping helps you to validate your concept for yourself, your team and prospective investors. Validation of the concept would mean that the startup team is in place, the product is ready and there are a few paying customers who are happy with the product and are willing to buy again and recommend it to their friends.

Once your concept is validated investors come in with much greater confidence and give you a much higher valuation then they would have at an earlier stage. You get to keep a larger share of your company for the same money. Most entrepreneurs don’t realise the importance of this until much later – should the company go on to become valuable.

Bootstrapping makes you stretch 24x7. It makes you think about survival, about how to break even, about where the next rupee is going to come from and about where it should be going or not going. You innovate more, you prioritise and focus on the essentials. You manage your cash flows better, you go out into the field and sell to customers yourself and you put in twenty hour workdays if required. It instils a culture of frugality in the company. This is a priceless asset.

At Naukri when we were bootstrapping, we had to break even to survive. We found ways of doing that - somehow. So by the time we raised money what we had to do was to scale up and enhance a validated business model. The fiscal discipline that bootstrapping enforced on us is now a part of our DNA. It ensured that we went through the meltdown and became profitable with 40% of the capital that ICICI gave us still in fixed deposits in the bank.

Bootstrapping ensures that you recruit missionaries and not mercenaries – after all you won’t have the money to pay high salaries. You will pay then in stock rather than cash – non believers will simply not join you. This core group of believers will be the people who will see you through the tough times that every early stage must go through.

It takes a lot of time and effort to raise money – preparing the pitch and the plan, doing the rounds of the investors and meeting the interested ones several times, negotiating and signing the term sheet, dealing with lawyers, going through the due diligence and negotiating and signing the final agreement. It is a six month process if you are lucky. This is precious time you can spend instead on building the product, putting together the team and finding paying customers.

And then after you raise the money you have to manage the investor – and that too takes time. The fact is that when you raise money you don’t just get the capital – you also get the capitalist. He will be on your Board and he will have ideas and suggestions to give – it’s called value addition. And he will have disproportionate powers. But you might want to do things your way. In such a situation it might be a good idea to take the business forward till you have something concrete to show and then raise capital.

So, commit yourself, validate an idea, build a team, be an entrepreneur, bootstrap now, raise money a little later.