For idea-stage startups, valuation is more of a creative drill than intricate calculations because they are often pre-revenue in nature and lack historical data. It’s hard to put a value on something that doesn’t exist. However, an investor would want to have a fair idea about potential returns.
“The only way to value a startup at an idea level is to see how much money it requires to survive for the next 12-18 months until the startup becomes ready to raise the next round,” says Harshad Lahoti, founding partner and CEO of ah! Ventures. “You will have to give the founder enough money to generate good traction. If not, he will not have that sort of traction to convince the next investor.”
Another step is to assess the viability and future potential of the idea. “The uniqueness of an idea and its competitive intensity, besides the potential of idea for speedy rollout and rapid scalability are select parameters to assign a basic ballpark estimated value to the intellectual property (IP) of the idea and its defendability,” says Bharat Banka, founder and former CEO of Aditya Birla Private Equity.
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Lahoti says that at a seed level, the ballpark figure of stake dilution is 15-30 per cent. So once an entrepreneur says he is willing to dilute 30 per cent for Rs 50 lakh or whatever the amount required until the next round, there emerges a valuation.
“Now, people would argue on how one can decide that, since 15-30 per cent would mean that the valuation will double – if I am investing Rs 5 crore for 15 per cent, it will be Rs 10 crore for 30 per cent,” points out Lahoti. “However, we have a bottom range and top range here. After that, how we pinpoint a particular number in that range rests solely on how well one negotiates.” The better negotiator gets a better deal, he says, adding, “I believe it’s more of an art than a science.”
Valuations also depend on a company’s road to profitability. A startup that is projected to be profitable in two years will be valued way more than the one with a five-year profitability plan. Entrepreneurs need to avoid valuation on unrealistic financial assumptions, because they will eventually have to deliver their expectations to investors.
“It’s hard to come to a logical number,” says Sushanto Mitra, founder and CEO of Lead Angels, an alumni focused angel network. Mitra outlines three parameters for valuation of an idea-stage startup. “Investors think of the possible valuation in the next round and the probability of getting funding. The higher the next-round valuation and possibility of getting funding, the better would be the valuation at the idea level,” he says. Second, they look closely at the track record, domain knowledge and opportunity cost of the founders. “Finally, it would depend largely on the target stake in the company based on the asked amount,” he adds.
One way entrepreneurs can put a value on their idea is to look at companies that operate in a similar space. They need to talk to their peers in the ecosystem and also to startups that have received funding from the same investor.
Although not an absolute requirement, many angel investors prefer startups in their locality. It helps them to interact more frequently and directly with the entrepreneurs to get real-time update on their progress. Also, a company in the heart of a startup hub such as Bangalore will be valued higher than a startup in Mysore or Visakhapatnam, just for the fact that competition drives up startup valuation. In a city such as Bangalore, there’s a higher degree of competition among investors. Investors agree that negotiating a lower valuation is easy with startups in remote locations.
Ashish Taneja, managing director at growX Ventures says that the key factor is the team. “A lot of average guys come up with brilliant ideas, but we don’t back them because it’s not just the idea, the real power lies in execution and that’s where you create value,” he says. “Average people won’t be able to foresee the future, they often quit early.”
Investors look for entrepreneurs who possess a strong will to survive the hardest times. “Ideas are dime a dozen. It is all about execution. An idea platform such as Quirky.com backed by GE, which gave 2 per cent equity to the ideators, shut shop. The only chance of getting valued for an idea is when the founding team has a strong patent or experience of building a successful startup,” says Avinash Kaushik, investor and founder at hardware startup accelerator RevvX. Kaushik also heads US-based Innoventure Partners in India.
Lahoti agrees. “In all the 22 startups that I have funded, there’s only one at the idea stage. The reason why I funded them is because the entrepreneur in his previous venture has exhibited that he’s capable of running a company right from conception, execution to exit,” he says.
Angel investors also prefer entrepreneurs to put in their money at the idea stage. There are very few people who back startups at the idea stage because the risk is high, says Lahoti. “Having an idea is just one per cent; 99 per cent is the execution of the idea. It’s all about whether the team has the ability to execute,” he adds.
Out of 2000 startups, 100 get funded and of this 100, only one will get funded on paper plans; the other 99 startups will have only good traction, points out Lahoti.
Startup founders should also consider convertible notes, which avoid the valuation dilemma at the initial phase and keep valuations open. A convertible note is like a soft loan with the difference that it does not need to be repaid as such and is converted into equity when the startup goes for the next level of funding.
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This article was originally published in Kotak Business Boosters
Image credit: raineugene.org