Startup valuations: All investors are not equal

By Manish Saxena Valuation of startups has always been an intriguing subject. What is even more intriguing is how the valuation figures of these startups (often called unicorns if the valuation crosses USD 1 billion) gets reported in public forums. Since successful startups frequently raise funds to grow, often the reported valuation figure for a particular startup is based on a simple extrapolation of the recent round of funding raised by the company. For example, if the company raises USD 100 MN for a 10% stake, it is generally perceived that the value of the entire company is 1 billion i.e. (100mn/10%). This is also often referred to as a fully diluted valuation. The fully diluted valuation assumes that all the shares of the company have equal rights and hence have equal value i.e. the value of 10% stake is representative of the remaining 90% stake. Though the fully diluted valuation seems intuitive and easy to understand, it does not take into account the preferences attached to the instrument through which the recent investor has invested in the company. These preferences lead to a very different value for different class of shares and hence the value of the entire company derived by simply dividing the amount invested with the stake acquired may not represent the true value of the start-up. This is particularly true in case the company is still in early stages and quite far from a possible IPO. In most cases, financial investors like PE or VCs invest in startups through preference shares (often referred as Series A, B, C etc) wherein, as the name suggests, the investors gets certain “preferences” compared to the common shares held by the promoter or employees. These preferences can be of various types ranging from innocuous like “tag along right”, “drag along rights” etc to very significant preferences like preference in distribution of company’s value over other investors in the event of a sale or liquidation of the company (referred to as “Liquidation Preference”). Though these may appear to be standard clauses in the investment agreement, the preferences assigned to investors can offer significant downside protection to investors in the event company value declines. As seen recently in India, with investors marking down their investments in ecommerce companies and startups, decline in value of companies is a reality and this is when the differential rights assigned to investors become prominent. The preferences assigned to the investor and its impact on the valuation can be better understood from an example. Assume that there is a company which has three shareholders each holding 1 common share in the company and none having any “preferences” over the other shareholders. Further assume that the company consists of an Asset (or the company’s business) whose worth is 300. As demonstrated in the figure below, let’s further assume that the company’s value can either go up or down in the next 2 years. In either case, since all shares are equal, the value of common shares will either move up or down in tandem with the value of the asset.  However, now assume that 1 of the shares has a preference attached to it wherein the holder of that share is entitled to a preference in distribution of the company’s value over other shareholders. This means that in the event of a sale of the company or liquidation, the proceeds from such sale or liquidation would be distributed to other shareholders only after the preference shareholder gets his original investment back. In fact, in certain cases the Liquidation Preference could be 2x or 3x, implying that the preferred shareholder needs to be paid 2x or 3x his original investment before other shareholders get any proceeds. This preference could lead to a significantly different allocation between various shareholders in case the company value declines. As shown in the figures below, in the event company’s value declines, the preference share holder is still able to recover his investment amount exacerbating the loss to common shareholders.  This preference, as demonstrated above, provides significant downside protection to investor holding a preference share. Because of this, the preference shares are generally priced at a premium to the common shares. In fact, in US it is a common practice to value the common shares and other preference shares issued by company including startups for complying with tax regulations. These valuations in US are commonly referred to as 409A valuations and are carried out using advanced models using option pricing methodologies. The empirical data derived from the 409A valuations indicates that the value of common shares is at a significant discount ranging from 30-60% to the preference share value. Going back to the earlier example, if an investor invests USD 100 MN in a start-up through preference shares for a 10% stake, it may not be reasonable to assume that the true value of the company equal to the fully diluted value i.e. USD 1 billion. Assuming that the remaining 90% is held by common shareholder and assuming even a lower end of discount of 30% on the preference share value, the 90% held by common shareholder would bet valued at USD 630mn ( (100/10%) x 90% x (1-30%)). Based on this the total value of the company comes to USD 730 mn (USD 100 MN + USD 630 MN), implying a much lower value than fully diluted value of USD 1 Bn. The above analysis clearly highlights that all investors are not equal- the stronger the preferences assigned to them, the lower would be the value of the common share and hence a lower implied value of the company based on the recent round of funding. Further, while negotiating with the investor, the promoters should carefully analyse the impact of these preferences in a downside scenario. In the absence of such analysis, the promoter is at a risk of losing a substantial value to the investors, in case the company value declines. The author is Director, Grant Thornton India LLP.