There is method to valuation

K Ramakrishnan vehemently debunks arguments that there is hardly any rationale behind how companies are valued. A host of factors go into how an enterprise’s valuation is arrived at, he says.

As Executive Director and Head of Investment Banking at Spark Capital Advisors, he should know. Spark has been involved in 24 deals in the last three years, aggregating nearly $1.5 billion.

It recently helped a ready-to-cook food products company raise money from a venture capital (VC) firm.

“The number that you use for a given methodology is a function of a whole host of parameters. Just because you are not privy to a whole set of information, it is wrong to conclude that some randomness has come in,” says Ramakrishnan, who has over two decades of experience in corporate finance and advisory services business.

In the last mile, he says, there is always subjectivity because you want to close the deal.

“You may walk some distance, somebody else may walk some distance and you may meet. But coming to that point, coming to that playfield is a journey you have undertaken with a lot of thought. At the last minute, you may use some tactic to get to closure,” he says.

He admits that valuation is a touchy subject for most, especially first-generation entrepreneurs, who have built a venture and are looking to rope in an investor to raise funds for the business, for doing so means giving up ownership to an outsider.

Entrepreneurs tend to identify themselves closely with the venture. Since they see the ventures as an extension of their own self and of the sweat and toil they have put in, their expectations of what they should get for shedding a part of their holding is much more than what they should realistically expect.

As more deals get reported, everyone believes his or her business is also eligible to get funded. However, entrepreneurs have no idea why some ventures get the money and why some do not, nor do they know why some businesses get it at a particular price and others at a different price. Valuation depends on the amount to be raised and the quantum of dilution in stake.

What they often fail to appreciate is the perspective of the VC or private equity (PE) player putting in the money. For VCs and PE firms, the fund they manage has a fixed life and they have to give a return to their investors when the life of that fund runs out.

That is why, investors start thinking of exit options even before they put in their money.

When a VC firm invests money, it would have assumed that the business would play out in a certain fashion and by the end of the fund’s life, it would be able to exit its investment, return the money to its investors and move on.

But that may not play out quite that way. The economic conditions under which the deal was concluded and those under which the funds seek an exit may be completely different.

Take, for instance, says Ramakrishnan, what happened in 2007-08, when a lot of funds invested in ventures here.

Now will be the time they will be looking for exit opportunities. In 2007-08, India was being recognised in the global scheme of things as a destination. Money was available.

All this led to a certain frothiness in the market. Valuations were what they were.

Growth stories that were told were ones of optimism. And, the rupee was around 45 to a dollar.

Subsequently, the rupee has taken a hit and 60 is the new normal. In the last three-four years, growth rates have been muted.

The result is that when a company expected in 2007-08 that it would be a ₹1,000-crore venture by 2014, it is only a ₹600-crore company now and that ₹1,000-crore mark is still a few years away.

Growth has taken a hit and there has been a compression in value. Therefore, investors would have realised that they had paid too much and some of them have done a bit of course correction, when they invested in follow-on rounds.

According to Ramakrishnan, the methods of valuing a company are time-tested and depend on the nature of the business. It could be done based on aspects such as assets, growth potential, operating profit, discounted cash flow and net profit.

The appropriate valuation methodology is then superimposed on the sectoral dimension.

The most important aspect is the entrepreneur himself. What is the entrepreneur’s outlook towards bringing in an outside investor? Is he looking for them to hold on to the business for ever or is he open to giving the investors an exit?

Ultimately, says Ramakrishnan, valuation is a function of fundamental theories of finance, applicability of what is relevant for a business, picking the right metric and putting the right number and trying to confirm it through other related methodologies.

After all this is done, it is a matter of negotiation, he adds.

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