Startup valuations need to be realistic

Summary:Tendency for startups to overvalue themselves when pitching for funds, partly due to success stories from Silicon Valley, but too high a price tag can turn off potential investors, market observers warn.

There is a tendency for tech startups to overvalue themselves when raising funds because of success stories from Silicon Valley in the United States, industry watchers say. They add that a realistic valuation is important as potential investors may lose interest if offered an unreasonable price.

Johnathan Lee, vice president of commercialization and ventures at Cradle Fund, for one, said a company that overvalues itself can be an obstacle for negotiations even before they begin, with some investors not even inclined to look at a company if it's too expensive.

The success stories of Silicon Valley startups--many of which are overvalued--have also impacted the way entrepreneurs in other markets such as Singapore view their own companies, in that they would similarly inflate their value, added Michiel Wind, CEO of Crystal Horse Investments.

"It is a bit of a problem, [and the] only thing we can do is reject overvalued companies and stick to the ones that are reasonably valued," he said.

How to value a company

There are several methods of calculating the value of a company, noted Narasimhalu. Here are three of them:

1. Value by proxy - identify a similar company and use its valuation at a similar stage of growth or existence.

2. Value by replacement - identify the investment required for a competitor to enter the market.

3. Value by P/E ratio (price-to-earnings ratio) - calculate the value using the price-to-earnings ratio for a similar company in the industry. For example, how much the company is worth divided by how much it is earning.

Willson Cuaca, co-founder and managing partner at venture capital firm East Ventures, also believed companies can be overvalued in countries such as Singapore where they have relatively easier access to funding such as government grants. Indonesia, on the other hand, has "relatively more fairly valued startups" and the market has plenty of business potential, which is why he chose to focus his resources in the country, he added.

Wind pointed out that for a company which has not made any sales yet, its valuation should not be "lofty" and unrealistic multi-million figures but remain in the six-digit realm instead.

After all, a company's valuation is based on its "ideas, research, contacts, and time and money spent" on building the business, the CEO said, and entrepreneurs cannot be too optimistic about their companies before they have achieved success in their fields.

Another misconception is "we are targeting China, and we 'only' need 1 percent of the Chinese to buy our product to make many millions per year, so our valuation should be sky-high", he pointed out.

Challenges in calculating right value

In terms of evaluating a company's market worth, Desai Arcot Narasimhalu, director of the institute of innovation and entrepreneurship at Singapore Management University (SMU), noted that there are several methods (see sidebar) and there is no right or wrong one.

He did state that valuation by P/E ratio calculation provides specific hurdles. "The earnings projections made by most founders are too aggressive and investors almost always discount such projections unless the management team is really very experienced within the industry," noted the SMU director.

Another popular method, the discounted cash flow (DCF) model, also has its disadvantages and is not favored by Crystal Horse Investments. Wind said the calculation uses many assumptions, which he finds "highly unreliable".

"DCF is a mathematical model whereby you have to predict many years in the future. [The permutations for] a startup company are; one, could easily be bankrupt by then; two, could have grown double digit rates per month; or three, could be anywhere between both," he said.

Just some small changes in conversion rate or monthly growth rate, and this would have tremendous effects on the outcome and the valuation, he added.

Breaking down the components

Cradle Fund's Lee said: "It's not easy to value a company. It's more of an art than science, it's almost like buying a painting."

Wind agreed, noting that it was not really a science, more of a mixture with some kind of "feeling".

As such, he suggested looking at the calculation backwards to get a better idea of the components involved in a valuation. "Let's first determine what would happen if we have a successful exit, and receive a nice amount of cash for our equity--the percentage of which will be diluted due to future rounds and employee stock option shares."

"It's not easy to value a company. It's more of an art than science, it's almost like buying a painting."

Johnathan Lee
Vice President,
Commercialization and ventures, Cradle Fund

The CEO pointed out that the company will then have to first deduct the initial investment, and possibly opportunity cost, as well as deduct the investments that have not done as well. Following which, it would have to deduct the wages of the staff and other expenses, leaving the remainder as the net profit. A portion of this profit will go to the employees as bonuses, he added.

Wind went on to describe how his firm might valuate a two-man team startup with a good personal backgrounds in areas such education, relevant working experience, etc.

"If they invested S$50,000 (US$40,425) of their own money, put three months of work in it, have an interesting and scalable idea, some sort of a rough prototype but no traction yet, a decent market size; all else being reasonable and good, I would say that an angel should get about 20 percent to 30 percent equity for a S$200,000 (US$161,700) investment," he elaborated.

While his firm does not charge for mentoring, some angel investors may do so, in which case the equity should then be a bit lower. "If a startup has ready sales, companies often go for a multiple of sales of roughly 2 to 3 times, but could be much higher, depending on profitability or potential, growth, market size, etc," he added.

Topics: IT Employment, CXO, SMBs, Start-Ups

About

Loves caption contests, leisurely strolls along supermarket aisles and watching How It's Made. Ryan has covered finance, politics, tech and sports for TV, radio and print. He is also co-author of best seller "Profit from the Panic". Ryan is an editor at ZDNet's Asia/Singapore office.

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