Valuation of Young Firms and Consequences for Entrepreneurs

Textbook methods of valuing young and startup firms have been described in considerable detail by authors like Aswath Damodaran in his seminal paper “Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges”. He contends that valuation has been practiced poorly by VC firms, and often comes down to a bargain between the entrepreneur and the venture capitalist. This has been dramatized in the American TV Series Shark Tank, where entrepreneurs seek investment to start, grow or save their business, and five VCs fight each other for a potential deal.

The landscape is changing fast, however, and VC firms have realized that true gains can be achieved by estimating value of a firm accurately to win the confidence of the entrepreneur. By understanding these new methods, entrepreneurs stand to have a better visibility of how venture capital firms think and act.



Source: Damodaran

Adopting the life-cycle view of the firm helps VC firms estimate cash flows, investments, revenues and ultimately returns on equity. This becomes the basis point for buying the right equity at the right price. Discounted Cash Flow model for valuation then becomes the preferred tool, however, there are a few caveats to its application that most VCs have learnt to cope with over time:

  1. Estimating Future Cash Flows: There are two popular approaches to doing this, top-down and bottom-up, of which we will focus on the first one. Starting by estimating the market size during the lifetime of the company and market share achieved every year going forward, revenues are estimated. From an understanding of typical industry operating margins, pre-tax income is calculated. Carefully adjusting for tax every year (since cumulated P&L losses remain untaxed), after tax income is derived. Assuming an industry standard for Sales/Capital Employed, amount of reinvestment required can be calculated. This reinvestment is further checked with the evolution of Return on Capital Employed, and compared with industry leaders. Removing reinvestments from After-tax income results in free cash flows.While the entrepreneur cannot do much in the final stages of valuation i.e. tax effects and free cash flow calculation, he must remain cautious at first four steps to achieve higher valuations:



  2. Estimating Discount Rates: To begin, the WACC rate needs to correspond to the target capital structure and the right estimates of cost of debt and cost of equity. For Cost of Equity, the firms will attempt to find average beta across public firms in the sector, and using the average D/E ratio of the sector, find the unlevered beta for the sector. Since the firm typically starts out with the owner pooling 100% of equity, the unlevered beta is scaled up by the average correlation of publicly traded firms to get a total beta. As the firm progresses, it will approach VCs who will offer equity at a higher level of correlation with the market, thus reducing risk (total beta) accordingly. When the firm finally goes public, sector beta will apply as the firm is completely exposed to market risk. At the same time, cost of debt will depend on interest coverage ratio and the implied synthetic bond rating (adjusted for firm size). The entrepreneur then sets in stone the target D/E and how he intends to grow towards it, and this helps in formulating WACC for every year of operations.In this process, the entrepreneur does not have too much influence on the computation. However, sector definition and identifying the right peer group in the public market becomes crucial to achieve better valuation from VCs. Also, being adamant about not taking debt may actually lead to higher discount rates and lower valuations if equity can be procured at a lower cost, and therefore target D/E structure should be decided early on and reflect optimality.
  3. Estimating Present Value and Adjusting for Survival: Now that the cash flows every year and discount rates have been projected, a few key factors that the VC will attempt to assess will be A) Terminal value, B) Survival of the firm and C) Risk of losing key management.
    1. The VC try to classify the firm among three broad categories. First, firms that will grow on to go public one day, second, firms that will grow conservatively beyond the forecast horizon, and third, firms that will liquidate at the end of the forecast period. Accordingly, the firm’s terminal value be calculated based on its growth rate at stability.With this in mind, the entrepreneur should assess the nature of his own business, and rather than designing fancy and far-fetched long-term mission and vision statements for his company, align his own aspirations for the business with the commitments made towards continuous double digit growth. The promise of continuous innovation and competitive differentiation, and the capability to do so, are the surest ways to ensure higher terminal value estimations.
    2. VCs have realized that valuations remain incomplete if the risk of firm failure is not built into the computations diligently. For this, either they will factor in survival rates of typical firms in that industry from past research, or use probit regression models based on firm specific features (like cash holdings, history of founders, the business it is in, debt conditions) or use more complex simulation models.This will be the hardest part for the entrepreneur to sell. If the VC decides to use any of its in-house models, only robustness of the business idea and simplicity in execution are what can save the entrepreneur’s skin. At the same time, correct valuation of tangible assets built over time becomes important in case the distress sale is actually carried out, and the entrepreneur will need to vouch for the quality of resources that he promises to bring in.
    3. Loss of a partner or a managing director due to either personal or professional reasons can slow down operations drastically, leading to either a capacity crunch or withering of demand, and VCs have come to realize that replacement of these key personnel within a firm needs to be accounted for too.As the VC assesses the topline and bottomline impact of such events, the entrepreneur will need to convince that his firm is not a one-man show. Having a cross-functional team where people are ready to wear multiple hats to run the business will boost the confidence of valuation experts.

Rijul is a PGP2 member of Entre Club, IIMA. He has been reading Damodaran a little too much these days, trying to find ways for entrepreneurs to outsmart sharks.


Marketing of Innovations: Value Trajectories and their Management


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In today’s world, value creation has become the cornerstone for all growth that companies undertake. And it is not just any kind of growth, whether you are a fledgling organization or a well established conglomerate, you need to grow in double digits. While this may seem like common industry knowledge, but evidence suggests that over 85% of Forbes 100 has been replaced from its position in the elite list because they failed to grow in double digits.

Double digit growth demands organisations to remain nimble and work on a light footprint, which is assumed to be easy for startups who create new value trajectories, and difficult for established organisations who are working towards governing existing value trajectories. All the same, any firm engaging with innovations must remain cautious of two common pitfalls:

1. Red Queen Effect: “And so the queen said to Alice, to stay in this garden, you must run fast, but if you want to get anywhere soon, you will need to run twice as fast.” This quote from Alice in Wonderland aptly describes the choice most companies face everyday, i.e. when sales fall, the knee-jerk reaction is to increase marketing and sales efforts or invest more in production capacities, running like hell in competitive markets but getting nowhere, rather than investing in R&D.

2. Xerox Rounding Error: In 1950s when Xerox was making sales around $20 bn, it was faced with the daunting task of growing at 10-12% every year. And so, it hired the best engineers and inventors of the world in its Xerox Labs, who would work on cutting edge technology. But when sales projections for the experimental projects were made, they amounted to a few million dollars, “A rounding error” as thought by the senior management. Thus, Xerox systematically gave no-go decisions to inventors who would later found companies like 3M, Symantec and Bell, and failed to recognise its systems and processes had gone wrong somewhere.

Realizing that markets have rapidly turned volatile, uncertain, complex and ambiguous (VUCA, as it is popularly called), systematic methods of research management and marketing of innovations are needed, not just for governing existing value trajectories, but for creating sustainable new value trajectories as well.

Innovations or new product introduction by any firm may fall into one of the several types:
1. Seasonal: Products that are introduced at certain times of the year, and benefit from market cycles.
2. Conversion: Transformed products, by changing existing features or attributes, such as packaging.
3. Me-too: Products that already exist and are known in the market, and are effectively copied by the firm.
4. Line Extension: Introduction of new stock keeping units (SKUs) into the existing portfolio
5. New to the firm: Innovations that involve radical use of components in a manner known in other industries but not in the industry that the firm operates in.
6. New to the world: Products or technologies which have never been seen before, and cannot fall into any of the previous categories

Out of all these categories, Me-Too products contribute over 65% of all revenue streams for most companies, but sustainable profit growth (~30%) is achievable through New to the firm or New to the world products. (Source: Boris Durisin, 2011) Managing this growth portfolio then becomes possible by using frameworks and tools like strategic buckets or bubble diagrams. One SBU in Exxon Chemicals, for instance, uses the following strategic bucket framework.


Source: Crawford and Benedetto, New Products Management, 10th Edition

Such a growth portfolio can easily help managers identify their own position, as well as map competitive dynamics on the same scale. A firm can then utilize several frameworks and tools for effectively managing both existing value trajectories and new value trajectories across all of their phases of development. Starting from opportunity identification right up to launch as well as post launch, it is possible for managers of innovation to take data based decisions.


However, no matter how hard one may try to structure innovation processes, one must keep in mind, that in essence, it is the spark of creativity that managers are dealing with when they head out into uncharted markets. And therefore, there must always be creative space for the next Nicola Tesla’s or Steve Wozniaks of the world, and as managers, it remains our challenge to nurture ideas and make them flourish.

Rijul is a PGP2 member of Entre Club, IIMA. He thought Entrepreneurship was all about change, so he decided to change the logo of the club.

Tools for managing data

For entrepreneurs who are not well versed with databases, here is a list of five tools which are useful in dealing with large data sets.

1. Open Refine =  Open Refine can be used for cleaning, refining and reconciling large sets of data

2. Yahoo Pipes = A powerful tool, this is used to combine feeds from various data sources on internet, and then perform operations on it

3. Google Fusion Tables = A great visualization tool, this tool asks users to enter link of the data source. The data is uploaded, and then various charts/ graphs can be built from it

4. D3JS  = A Javascript library, which can be embedded in a website, this tool helps to make great charts, diagrams and maps

5. Open Heat Maps = This tool can be used to see data visualizations over time. Data can be uploaded through excels or google docs. There should be some location linked information through IP addresses, street addresses or longitude and latitude coordinates

Link Fest – 1


Each week, we intend to bring you a medley of the best posts about entrepreneurship from internet. In this series, we bring you diverse links which assembles advice from people who have done it and seen it all

1. Paul Graham makes a case that a start up is equivalent to growth. He argues, that any company, irrespective of whether it is in tech or not, can be called a start up if it is capable of showing exponential growth

2. Kyle Gerrity, Slader co-founder talks about learning to think beyond performance metrics of online websites and focussing on important indicators that will indicate how well a startup is doing.

3. With a passion for traditional food and a zeal for Indian culture, Jayanti gave up her plum job as a project manager in Infosys to start her own catering business based on authentic Marathi Cuisine in Bangalore.

4. A presentation of Guy Kawasaki’s (an Apple evangelist and start up guru) famous book called “The Art of the Start”. It talks about the ten important things which an entrepreneur needs to master while starting up.

5. David Skok, a five time serial enterpreneur turned VC, talks about the importance of business model in a startup. He contends that instead of technology innovation being the driver for startups, it is more frequently business model innovation.