There is a method to the valuation madness

Every once in a while, a phenomenon occurs that ignites popular imagination and creates paradigm shifts. In the start-up world, Unicorns are one such, and have dominated dialogues in recent years. Simply put, Unicorns refer to those start-ups that have achieved billion dollar valuations.

While experienced investors would not attach much meaning to these valuations, because of the clauses and structures such as liquidation preferences (what Wodehouse would probably refer as wheels within wheels), it did whip up a frenzy in the venture market.

Beauty is bought by judgment of the eye, as we see in Love’s Labor Lost . And so it would seem with venture valuations. However, when we looked at the venture valuation multiples with a microscopic eye, as Polonius said, the patterns did suggest a method to the madness.

What are valuation multiples – the so-called X factor? Let’s say a VC invests ₹10 crore for a 10 per cent stake in a start-up. This implies that the derived valuation of the venture is ₹100 crore. Let’s say the venture has annual revenues of ₹20 crore. Then the revenue multiple at which the investment happened is ₹100 crore divided by ₹20 crore, which is 5. This is the X-factor, or the valuation multiple. The entrepreneur, naturally would prefer to bargain for as high a multiple as possible, because a higher multiple would mean a higher valuation and thereby a lower dilution of the founder’s shareholding.

First, we looked at the trend in revenue multiples over the years based on an analysis of several thousand deals. What we found was an unmistakable upward trend - the average revenue multiple has increased from 2.21 for investments made in 2004 to 6.77 in 2015. The secular trend indicates that entrepreneurs of today seem to be more fortunate than the entrepreneurs of yore, at least in terms of valuation multiple.

Second, valuation multiple also depends on the industry and the stage of the venture. Technology sectors such as Internet Marketplace and E-Commerce (IM&E) characterised by high growth and innovation led businesses have traditionally enjoyed higher revenue multiples. Manufacturing has the lowest revenue multiple in general. With increasing maturity of the venture, the valuation multiples tend to decline. Early stage ventures have higher multiples compared to that of growth stage ventures, which in turn have a higher multiple as compared to that of late stage ventures.

Third, the higher multiple that entrepreneurs seek does not come free; there is a trade-off. Ventures get a higher multiple when the owners dilute a higher percentage of their shareholding. In addition, multiples are generally higher in a deal with a structured investment (such as convertibles) as compared to that of straight equity.

The logic is not that difficult to understand. All things being equal, investors are willing to give a higher multiple when they get a higher control in the company or better downside protection. To be or not to be, that’s the question the founders have to answer as they chase higher multiples.

In summary, valuation multiples are important. A high valuation multiple gives a high adrenalin effect to the founders as well as the employees of the venture. Importantly, multiples are also a barometer for market sentiment. The bystander though should not be unnecessarily swayed by the meteoric valuation numbers of the recent past. For there is a lot of fineprint, and a high X multiple conceals more than they reveal.

The writer is Professor, Department of Management Studies, IIT-Madras

COMMENT NOW