Valuation of Early-Stage (Start-Up) Companies

Valuation of
early stage (Start-up)

companies
December 2020
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Valuation of early stage (Start-up) companies 3
Contents
Foreword 3
Lifecycle of early stage companies 5
Stages of funding 7
Valuation methods 9
Valuation of complex securities 15
Sources 21
4 Valuation of early stage (Start-up) companies
Foreword
Navin Vohra
Partner India Head - Valuation, Modeling and Economics
Strategy and Transactions
Valuation of a traditional company, on any Valuation of start-ups: Balance between art

V given day is a complex exercise given the
need to analyze historical financials for
and science
past performance, evaluate and accurately estimate
the future earnings potential of the company while Science Art
reconciling the same with what a market player
would pay for a similar company. Valuation of a
start-up / high growth internet company is entirely Cash burn
a new dimension added to the complexities faced
DCF Quality of
by a valuation professional. Limited historical
performance, high cash burn rates and little or no growth
Market
profits in the immediate future are just a few factors approach Stage of
which a professional has to contend with.
development
Given the challenges involved, it is important to
understand the lifecycle and stage of funding of the
early stage company. It is also important that one
understands how the whole Indian e-commerce and
consumer internet sector has evolved before one can
value a start-up. This document attempts to introduce
these aspects before suggesting popular valuation
techniques that one may apply to value a start-up.
Inherent challenges in valuation of start-ups
Limited Losses
historical High cash Founders’
or limited
financial burn credentials
data profits
Recent Stage of Customer

funding development traction
Evolution of the Indian e-commerce and consumer internet (ECCI) sector
The ECCI sector has had multiple waves of entrepreneurship but it was in the last decade when the inflow of large
amounts of capital from marquee global investors made its way to Indian shores and cemented itself as one of the most
exciting destinations and area of innovation and disruption.
1
• India currently has over 504 million internet users, however digital transactions are still low and this provides for a
massive opportunity for growth and expansion for ECCI companies.
2 3
• As at 30 June 2020, India has 24 Unicorns in the ECCI sector with average valuation of US$3.5 billion. It is
4
expected that 52 ECCI companies in India are potential unicorns. It typically takes approximately five to seven
years for an ECCI company to become a Unicorn in India, which is ahead of USA (six to eight years) but is a step
behind China (four to six years).
5
• In 2019, India was positioned at 52nd rank in Global Innovation Index with Bengaluru ranking amongst top three
cities globally for launch of tech ECCI companies.
6
• India’s e-commerce market has reached US$200 billion in 2019. It has a significant avenue to provide employment
and building micro-entrepreneurship in the country.
Waves in ECCI sector Factors fueling the Indian digital economy

7 8
Internet wave Globalization wave
Yahoo!, Amazon, Facebook and Twitter in US Sustained

Rise of Availability
Google in US growth in Low mobile
Flipkart and Zomato in India internet of affordable
disposable data tariffs
Just Dial, penetration smartphone
income
MakeMyTrip.com
2003 -
and Naukri.com in
India 2008
2009
1994 - onwards
Digital
2002 Support and
payment COVID-19
Smartphone wave
9
stimulus Improved
acceptance (pandemic
by govt. digital literacy
Uber and Airbnb in US infra- situation)
programs
structure
Ola and Oyo Rooms in India
01
Lifecycle of early stage
companies
10.1%
Others
Lifecycle of early stage companies
4 5
2 3 Maturity
stage
1
Scale-up
• Exit / IPO /
stage M&A
Growth stage • Repeatable
user
• Early traction acquisition
Seed funding
• Loyal • New growth
customer base channels
• Early revenue
Idea validation • Series A, B • Series C and
• Self funding rounds of above rounds
• Idea • Funds from funding of funding
formulation friends /
family/crowd
• Idea validation
• Angel
• Prototype
investment
• Minimum
viable product
10
Lifecycle of an early stage company
02
Stages of funding
Stages of funding
1 2 3
VCs, PEs, acquisitions / mergers and
Angels, friends and family Early stage
strategic alliance / IPO
Seed capital Institutional investors Later stage

Revenue
Time
1st round 2nd round nth round

Valley of death Mezzanine IPO
of funding of funding of funding
10
Phases of funding
03
Valuation methods
Valuation methods
Valuation methods for start-ups
The core of valuing a start-up always revolves around the earnings that the company is able to generate. The following methods
are often used by angel investors/ venture capitalists to estimate the value while making the investment/divestment decisions.
Some of these methods borrow concepts from traditional valuation approaches. It should be noted that for valuation for financial
reporting, other methods such as calibration, back solve, etc. are used.
• Based on five parameters: Sound idea, prototype,

quality of management team, strategic relationships
and product roll out or sales
• Assigning range of values to pre-revenue companies as
start-up begins to make progress
Berkus
• Combination of DCF • Adjustments to

and market multiple
methods giving weights
1 valuations of
comparable cos. based
to normal, best and First on scores assigned to
Scorecard
worst case scenario Chicago
5 2 each metric of target
4 3
Venture Risk factor
capital summation
• Employs a forecasted terminal
value and an expected return from • Combination of
investor to determine pre-money Scorecard and Berkus
and post money valuation method
• Terminal value = exit multiple x

targeted revenues (or) earning in
exit year
Valuation methods
1 Berkus method [for pre-revenue stage companies]
The Berkus method of valuing a start-up gives value to those elements of progress made by the entrepreneur or team that reduces
the risk of success. The method assigns a range of values as the company begins to make progress.
If the following parameter exists in the company Add to company value

Table 1
Sound idea (primary value) + US$ 0.5 million
Prototype (reducing technology risk) + US$ 0.5 million
Quality of management team (reducing execution risk) + US$ 0.5 million
Strategic relationships (reducing market risk) + US$ 0.5 million
Product rollout or sales (reducing production risk) + US$ 0.5 million
Total value = US$ 2.5 million

*The above mentioned maximum US$ 0.5 million is an illustrative number and may change depending on factors like
geography and risk element in question
Limitation(s): Once a company starts generating revenue, this method is no longer applicable as everyone would use actual
revenues to estimate the company value.
2 Score card method [for pre-revenue stage companies]
This method compares the target company to typical angel-funded start-up ventures in similar stage of development, business
and region. Thereafter this method adjusts the average valuation of selected companies to establish a pre-money valuation of the
target company.
Comparison parameters Weight Target company’s score Factor

Table 2
Strength of management 30% 125% 0.375
Size of the opportunity 25% 150% 0.375
Product / Technology 15% 100% 0.150
Competitive environment 10% 75% 0.075
Marketing/Sales/Partnerships 10% 80% 0.080
Need for additional investment 5% 100% 0.050
Other factors 5% 100% 0.050
Total [a] 1.155
Average pre-money valuation (based on comparable companies) [b] US$ 20 million
Pre-money valuation of target [c=axb] US$ 23.1 million
Limitation(s):
• Determination of company’s score may be a subjective matter

• Data availability with regard to similar comparable companies can be a challenge
Valuation methods
3 Risk factor summation method [for pre-revenue stage companies]
• Risk factor summation method is a combination of Berkus and score card method with the analysis of a wider set
of risk factors.
• This method forces investors to think about the various types of risks which a particular venture must manage in
order to achieve a lucrative exit.
Risk assessment grade Rating

Table 3
Very positive +2
Positive +1
Neutral 0
Negative -1
Very negative -2
Risk assessed Grade Rating

Table 4
Management Very positive +2
Stage of the business Neutral 0
Legislation/Political risk Neutral 0
Manufacturing risk Neutral 0
Sales and marketing risk Neutral 0
Funding/capital raising risk Neutral 0

Competition risk Very negative -2
Technology risk Positive +1
Litigation risk Very positive +2
International risk Neutral 0
Reputation risk Very positive +2
Potential lucrative exit Neutral 0
Total +5
Value of assigned points (Each point is assigned a value of US$ 0.25 million ) [a] US$ 1.25 million
Average Pre-money valuation (based on comparable companies) [b] US$ 20 million
Pre-money valuation of target [c=a+b] US$ 21.25 million
Limitation(s):
• Determination of risk assessment rating may be a subjective matter

• Data availability with regard to similar comparable companies can be a challenge
Valuation methods
4 Venture capital method
• The Venture capital method entails forecasting a future value (e.g., three years from the present) and
discounting that terminal value back to the present by applying a high discount rate.
• This method is useful for valuations of pre-revenue companies where it is easier to estimate a potential exit value
once certain milestones are achieved.
• For example, let us assume that a health tech company is expected to have a revenue of US$ 25 million after
three years and the price to revenue multiple is 4x for a similar publicly listed company, this would mean the
value at the end of three years is 25 * 4 = US$ 100 million.
• This value of US$ 100 million should be discounted to present value using a venture capital expected rate of
return, say 25%, i.e., 100/(1+25%)^3 = 51.2. This is the post money valuation. If the investor would invest say
US$ 10 million , then the pre-money valuation is US$ 41.2 million.
Particulars Value
Table 5
Anticipated exit/terminal value [a] US$ 100.0 million
Anticipated return on investment (ROI) / WACC [b] 25
Expected period in years [n] 3 years
Post-money valuation [c=a/ (1+b%)^n] US$ 51.2 million
Investment amount [d] US$ 10.0 million
Pre-money valuation [e=c-d] US$ 41.2 million
Limitation(s):
• Anticipation of exit value based on expected financial outcomes or milestones to be achieved in the forecast
period is a subjective assumption.
• Determination of ROI is another subjective assumption as it is based on the perceived risk of a given investor and
can produce varying results between investors.
Valuation methods
5 First Chicago method
• The First Chicago method was developed by the venture capital arm of the First Chicago bank.
• This method is a combination of discounted cash flow and multiple-based approach. It evaluates the risk involved
in forecast cash flows using various scenarios viz. “Base case”, “Best case” and “Worst case”.
Base Case Best Case Worst Case

Table 5
Particulars
(US$ million) (US$ million) (US$ million)
Revenue as at Year 0 10 10 10
Annual revenue growth for explicit period % 20% 30% 10%

Sum of present value of cash flows for explicit period (in this case
49.5 63.0 38.7
five years) at a high discount rate (25%)
Exit EV/revenue multiple based on comparable companies deals 3x 3x 3x
Discount rate 25% 25% 25%
Present value of terminal value 27.3 40.8 17.7
Sum of explicit and terminal values 76.9 103.8 56.4
Scenario Weights 50% 25% 25%
Weighted Values 38.4 25.9 14.1
Value of the target (sum of weighted values) 78.5
Limitation(s):
• Application of a constant revenue growth through the entire discrete period may not be a true representative on
how a business may grow.
04
Valuation of complex
securities
Valuation of complex securities
• Generally, start-ups are funded through a blend of equity stocks and preferred stocks that have the properties
of both debt and equity such as compulsorily / optionally convertible preference shares, etc. Issuing complex
instruments help companies to attract a wider variety of investors with different needs and temperaments. It is
therefore important to understand the valuation of these complex securities to value the overall start-up.
• Typically, a preference shareholder’s investment is protected by liquidation preference right as it gives first
priority to preferred stakeholders over common stock holders at the time of distribution. However, if the
valuation of company is higher than the entry valuation of preferred shareholder then, the investor may convert
into equity shares.
• Further, if subsequent investment occurs at lower valuation, the preferred shareholder stake is protected from
getting diluted through anti-dilution right. This right results in automatic readjustment of the original conversion
ratio of preferred stock to common stock.
• Issuance of multitude of such instruments (including convertible preference shares, convertible debentures, etc.)
create a complex capital structure. Given that rights of different classes of instruments are different, therefore,
valuation of equity interests in complex instrument requires complex approaches rather than distributing the
value on a purely pro-rata basis.
• Valuation of privately held equity securities issued by AICPA provides the following widely accepted valuation
methods for allocation of equity value among different classes of shares:
• Current value method (CVM)
• Probability-weighted expected return method (PWERM)
• Option pricing method (OPM)
• Typically, compound instruments enjoy a liquidation preference over the equity shares, i.e., priority over equity in
receiving value in case of certain events.
• Further, the value of liquidation preference is different across different series, with each latter series of
preference shares progressively enjoying priority over equity shares in the proportion to liquidation preference.
Hence, compound instruments needs to be valued differently.
Illustration: How liquidity preference works and impact on the value of the securities:
A privately held company, Sample Private Limited (Sample), has following classes of shares:
• 1 Series A convertible preference share, convertible into equity in the ratio of 1:1 with liquidation preference
of INR500; and
• 1 equity share.
Then the distribution of the overall equity value of the company will happen in the following manner:
Distribution of liquidation 550

proceeds at different values (in INR) 500
200
0 100 Preferred shareholder
Equity shareholder
500 500 500 500 550

0
0 100
0 0
0 100 500 600 700 1,000 1,100
• These rights gives provides a characteristics of both a bond and shares to convertible preferred shareholders,
wherein the investor has first right on capital, till the protection amount. If the equity value of the subject
company Is higher than the liquidation preference amount, the investor can convert the its convertible shares to
equity shares and enjoys the equity upside.
• Below is the graphical presentation of payoff of a typical preference share.
Bond payoff Call Option

600
600
500
Call option (INR)

500
Bond payoff (INR)
400
400
300
300
200
200
100
100
0
0
200
400
600
800
1000
1200
1400
1600
1800
2000
0
200
400
600
800
1000
1200
1400
1600
1800
2000
0
Company valuation (INR)

Preference share payoff

Preference share payoff INR
1100
1000
900
800
700
600
500
400
300
200
100
0
100
200
300
400
500
600
700
800
900
0
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000

Complex securities valuation comes with its own set of challenges
Payoffs are non-symmetrical (due Scenario analysis depending on variable

to derivative features, different outcomes in the future
scenarios and conditions

economic rights of various classes)
Multiple funding rounds, investment in
Estimating payoffs
Factoring multiple
and vary across a range of possible
tranches with valuation for each tranche
outcomes
dependent on multiple conditions add to
Determining cash complication
flows is complicated:
dependent on
multiple conditions
in contracts,
agreements, rights
offered to other
classes, etc.
Valuing complex
securities
Highly structured instruments
Lack of market benchmarks

Each instrument is
unique, underlying
No active market for
variables are several
similar securities,
and varied, can be
data on similar
highly structured with
transactions is
multiple conditions (vis-à-vis a
sketchy
straight equity / debt) which need
to be modelled Private company valuations based on
latest rounds of funding as reported can
A range of possible outcomes with multiple
be misleading - when capital structure is
inter-dependent variables needs to be
complex, specialized techniques needed to
considered
value equity
• There are three methods of valuing a compound instruments which are internationally acceptable.
1 Current value method (CVM)
• CVM allocates equity value to various class of shares based on their liquidation preferences or conversion values,
whichever is greater.
• This approach is useful where the enterprise is going for an immediate sale or the enterprise is at such stage of
development that no material progress has been made on the enterprise’s business.
Limitation:
• It is not forward looking and fails to consider the option-like payoffs of the share classes.
• In absence of a liquidity event, the method fails to consider the possibility that the value of the enterprise will
increase or decrease between the valuation date and the date at which common stockholders will receive their
return on investment.
2 Probability-weighted expected return method (PWERM)
• PWERM considers the value of preferred and ordinary shares based upon an analysis of expected future equity
values assuming various future outcomes, including IPO, dissolutions or continued operation as a private
company.
• This approach is useful where the enterprise is close to an exit and does not plan to raise additional capital.
Further, this approach is more appropriate when the time to liquidity event is short, making it easier to predict the
range of possible future outcomes.
Limitation:
• Involves complex construction of probability models and depend heavily on subjective assumptions.
• It is not appropriate to value option like payoffs.
3 Option pricing method (OPM)
• OPM considers preferred and ordinary shares as the call options on total shareholders’ equity value, giving
consideration to the rights and preferences of each class of equity shares.
• OPM is the most appropriate method to use when specific future liquidity events are difficult to forecast.
• This approach recognizes the options like pay-off of the various class of shares.
Sources Note no.
2
Source
‘India Internet as at November 2019’ by IAMAI (Internet and Mobile

Association of India)
Tracxn
EY Analysis
Tracxn
3
EY Analysis
4 The Wire
5 Global Innovation Index 2019 rankings report
6 Retailers Association of India (RAI)
ICAI – Valuation Professional’s Insight_Series 2

Internet Wave: Entrepreneurs who started companies between
7 1994 and 2002 imagined the possibilities of a new world with the
Internet. Yahoo!, Amazon, and Google in the US, and Just Dial,
MakeMyTrip.com, and Naukri.com in India are typical examples
Globalization Wave: Entrepreneurs who started their companies
between 2003 and 2008 did not internalize the rules of doing
business before or during the dotcom bubble burst, yet could
8 not imagine a life without the Internet, and were naturally more
global in their thinking than their predecessors. They are the
global entrepreneurs. Facebook and Twitter in the US and Flipkart
and Zomato in India are examples of companies started in the
globalization wave.

Smartphone Wave: Entrepreneurs who started their companies
9 in 2009 or later, do not have muscle memory of the world before
the financial crisis and cannot imagine a life without mobile apps.
These are the smartphone entrepreneurs. Uber and Airbnb in the
US, and Ola and Oyo Rooms in India are perfect examples.
Govt. of India, Ministry of Commerce & Industry – States’ Startup

10
Ranking 2018
For any further enquiries, please contact:
Navin Vohra
Partner India Head - Valuation, Modeling and Economics
Email: Navin.Vohra@in.ey.com
Parag Mehta
Partner
Email: Parag.Mehta@in.ey.com
Amish Mehta
Partner
Email: Amish.Mehta@in.ey.com
Arun Rathnam
Director
Email: arun.rathnam@in.ey.com
Atul Gupta
Vice President
Email: atul.g@in.ey.com
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Valuation of

early stage (Start-up)

Click here to navigate

Valuation of a traditional company, on any Valuation of start-ups: Balance between art

Inherent challenges in valuation of start-ups

Recent Stage of Customer

Evolution of the Indian e-commerce and consumer internet (ECCI) sector

Waves in ECCI sector Factors fueling the Indian digital economy

Yahoo!, Amazon, Facebook and Twitter in US Sustained

Lifecycle of early stage companies

Seed capital Institutional investors Later stage

1st round 2nd round nth round

Valuation methods for start-ups

• Based on five parameters: Sound idea, prototype,

• Combination of DCF • Adjustments to

• Terminal value = exit multiple x

1 Berkus method [for pre-revenue stage companies]

If the following parameter exists in the company Add to company value

Sound idea (primary value) + US$ 0.5 million

Prototype (reducing technology risk) + US$ 0.5 million

Quality of management team (reducing execution risk) + US$ 0.5 million

Strategic relationships (reducing market risk) + US$ 0.5 million

Product rollout or sales (reducing production risk) + US$ 0.5 million

Total value = US$ 2.5 million

2 Score card method [for pre-revenue stage companies]

Comparison parameters Weight Target company’s score Factor

Strength of management 30% 125% 0.375

Size of the opportunity 25% 150% 0.375

Product / Technology 15% 100% 0.150

Competitive environment 10% 75% 0.075

Marketing/Sales/Partnerships 10% 80% 0.080

Need for additional investment 5% 100% 0.050

Other factors 5% 100% 0.050

Total [a] 1.155

Average pre-money valuation (based on comparable companies) [b] US$ 20 million

Pre-money valuation of target [c=axb] US$ 23.1 million

• Determination of company’s score may be a subjective matter

3 Risk factor summation method [for pre-revenue stage companies]

Risk assessment grade Rating

Risk assessed Grade Rating

Management Very positive +2

Stage of the business Neutral 0

Legislation/Political risk Neutral 0

Manufacturing risk Neutral 0

Sales and marketing risk Neutral 0

Funding/capital raising risk Neutral 0

Technology risk Positive +1

Litigation risk Very positive +2

International risk Neutral 0

Reputation risk Very positive +2

Potential lucrative exit Neutral 0

Average Pre-money valuation (based on comparable companies) [b] US$ 20 million

Pre-money valuation of target [c=a+b] US$ 21.25 million

• Determination of risk assessment rating may be a subjective matter

4 Venture capital method

Anticipated exit/terminal value [a] US$ 100.0 million

Anticipated return on investment (ROI) / WACC [b] 25

Expected period in years [n] 3 years

Post-money valuation [c=a/ (1+b%)^n] US$ 51.2 million

Investment amount [d] US$ 10.0 million

Pre-money valuation [e=c-d] US$ 41.2 million

5 First Chicago method

Base Case Best Case Worst Case