The true value of Indian unicorns: Investment game

A report in Mint earlier this month mentioned that Indian e-commerce firms Flipkart and Snapdeal have hit a “valuation wall”, with prospective investors unwilling to meet their latest headline valuations of $15.2 billion and $6.5 billion, respectively. This followed moves by T Rowe Price and Morgan Stanley in marking down the valuation of Flipkart to $12.75 billion and $11 billion respectively in their investor declarations.

Taken together, this possibly suggests that these e-commerce biggies might be in trouble, and possibly unable to compete with the Indian arm of Inc. While that is a plausible conclusion, there is another factor that might explain both the valuation discount and companies’ unwillingness to raise money at lower valuations—the optionality granted to investors.

When an investor invests Rs.1 crore for a 10% stake in a start-up, it is a common practice to assume that this investment values the start-up at Rs.10 crore. While this is intuitive and arithmetically sound, the problem is that it ignores the optionality that is inherent in any start-up investment.

Given the risks associated with investing in a start-up, investors usually demand some downside protection. While this downside protection comes in various forms, one of the most popular (and simple to understand) structures is called the “full ratchet”. According to this, existing investors in a company (this usually includes the founders) underwrite the new investor’s investment, and agree to fully compensate the new investor in case of a subsequent fall in the company’s valuation.

Let us assume that company XYZ raises Rs.1 crore from an investor, Alpha Partners, in exchange for a 10% stake. This investment gives XYZ a “pre-money” (excluding the fresh investment) valuation of Rs.9 crore, and a “post-money” (including the investment ) valuation of Rs.10 crore. Let’s say that a few months down the line, XYZ hasn’t done as well as expected, but needs fresh funds, which Beta Partners agrees to provide. Beta, however, insists on a pre-money valuation of Rs.8 crore.

Ordinarily, the value of Alpha’s investment would go down from Rs.1 crore to Rs.80 lakh (10% of Rs.8 crore). However, because Alpha had a “full ratchet” clause attached to its investments, the earlier investors (including founders) have to compensate Alpha with shares worth Rs.20 lakh (the difference in valuation). This way, despite the firm having not done too well, Alpha’s investment has remained protected, with older investors bearing the downside risk.

The true value of Indian unicorns

In other words, while the original agreement gave Alpha a tenth of the shares, Beta’s investment at a lower valuation means that Alpha now has an eighth of the remaining shares (though the total value of these shares remains the same). An even lower pre-money valuation by Beta would have resulted in a higher transfer from the original investors to Alpha.

This way, it is not hard to see that the full ratchet that was part of Alpha’s investment agreement is essentially a put option written by the older investors in favour of Alpha. There would be no problem if Beta’s pre-money valuation was higher than Alpha’s post-money valuation.

The lower Beta’s pre-money valuation is, the more the original investors must transfer to Alpha (this is limited by the number of shares the original investors retain. If Beta’s pre-money valuation is lower than Alpha’s investment, the original investors are completely wiped out, and we can assume that the company itself might cease to exist then).

Thus, for the Rs.1 crore that Alpha Partners invested in XYZ, it not only got a 10% stake in the company, but also a put option that protects its investment against a lower valuation in a further round. This put option is written by the existing investors in the company at the time of Alpha’s investment.

This implies that a share of the company held by Alpha partners includes a long put option, while a share of the company held by earlier investors includes a short put option (since they have implicitly written this option). In other words, a share held by the new investors is worth much more than a share held by earlier investors. Alpha might have invested Rs.1 crore for a 10% stake, but the value of the company is far less than Rs.10 crore. In order to determine the precise valuation, we need to value the put option.

Valuing a put option in a start-up is different from valuing one in a publicly traded company. The most important difference is the way in which the price moves—while it is slow and steady for a public company, start-ups either grow fast or die, implying we need a different process for prices or returns. Moreover, opportunities for trading in start-up companies are fewer, and the full ratchets don’t come with an expiry date attached, implying we need a different model to value such options.

The true value of Indian unicorns

With the formula in hand, we can now value the option embedded in investments in start-ups, and what this tells us about the overall valuation of the company. Starting with our example, for a Rs.1 crore investment for a 10% share of the company, the value of the full ratchet option can be derived from this formula as Rs.27.8 lakh. In other words, the Rs.1 crore that Alpha invested pays for both a 10% stake in XYZ as well as an option worth Rs.27.8 lakh. The stake itself thus costs only Rs.72.2 lakh, implying that the full company can be valued at Rs.7.2 crore (compared to the Rs.10 crore headline valuation).

We can now apply the formula to the latest round of venture capital investments in a few popular Indian private companies. It must be noted, though, that these investments need not have come with a full ratchet protection, and the valuation is sensitive to the nature of protection used (sometimes the ratchet can be set at a higher strike price. At other times, a “weighted average” method could be used to determine the transfer of shares, which decreases the option payout).

It is interesting to note that Morgan Stanley’s reported valuation of Flipkart is not very far from the value we have calculated assuming a full ratchet downside protection (along with other assumptions).

An additional feature of downside protection instruments such as ratchets is that they “telescope”. Each round of investors is long an option that comes along with their investment, but short another option that comes with the next round of investment! Thus, with every succeeding round of increasing valuations, investors from the previous round can go from being long a put option to being short an option. And this creates conflicts when it comes to fund raising.

The latest round of investors usually don’t mind a “down round” (an investment round that values the company lower than the preceding round) since their ratchets protect them, but earlier investors are short such ratchets, and don’t want to see their stakes diluted. Thus, when a company is unable to find investors who are willing to meet its current round of valuation, it can lead to conflict between different sets of investors in the company itself. When US-based payments company Square went public in 2015, about $93 million worth of stock had to be paid out to its last round of private investors. These investors had been promised a 20% return on their investments, and when the initial public offering (IPO) had to be priced low, they had to be compensated with additional stocks. It is interesting to note that Goldman Sachs and JPMorgan Chase & Co., who held ratchet options after having invested in the last private round, were also among the underwriters to the IPO.

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