The (Un)-Necessary Trials and Tribulations of Valuation An asset can be deemed very valuable by one while being dismissed by another so the challenge is to find the real value
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There is only one really mathematical way that everyone will agree on to price equity. Its called Discounted Cash Flow. (DCF). You take the cash generated by the business today and then project the cash generated for the years to come, discount the future cash flows and add it all up. The discount can say, what is the normal risk-free return in the market – for example, what you get an FD from a bank or a govt. bond. For an Indian rupee asset, 10% is a good round approximation.
Hence, valuation for a company: (CGYn = Cash generated in Year n)
CGY0 + CGY1/10% + CGY2/(10%)^2 + …. + CGYn/(10%)^n.
Simple enough? Very precise and mathematical?
The spanner in the works is – how does one project future cash flows? There are technology businesses that are negative cash flow today but can generate huge amounts of cash flow tomorrow, and vice-versa. How does one model product/market fit risk? What about the competition? What about change in the environment?
Challenge in the Real Life
Hence, in real life, valuations are very hard to arrive at. It depends on one's view of the future. And hence, beauty lies in the eyes of the beholder. An asset can be deemed very valuable by one while being dismissed by another. Hence in a public market, there are buyers and sellers at different prices. And the great circus of the stock markets is played out every day, every minute, leading to real-time price discovery.
Extrapolate this to the tiny startup companies – much lesser predictability, much higher uncertainty, not enough buyers and sellers unlike public markets, to establish a real-time price. Not enough beholders beholding regularly. So how does one price assets? What valuation can an investment happen?
Private investors, whether they are angels, VCs, PEs, strategic or some mix in between price assets based on their own experiences, market reference points, risk reward and so on. There are a bunch of thumb rules that rule. High growth SaaS companies can be 10x revenue. High growth consumer market places can be 1-2x marketplace throughput. So on and so forth. These are in no real way scientific or very well thought through and specifics vary a lot transaction to transaction
Hence, an Entrepreneur, this is how you Should Look at it:
Funding has to be first and foremost looked at as fuel for business. No fuel, no more journey.
Your job as an entrepreneur as you fundraise is to create a real market for your equity in the private world. You do it by representing your company to the best of your ability and pitching to several players in the market.
At the end of this process of market making, whatever price you get is the real price. There is no lower or higher price. You may choose to raise a lower amount of money if you don't like the price to reduce dilution and you may choose to raise a higher amount of money if you feel markets have been generous.
You repeat the above process through the journey of the company. Dil pe mat le yaar - Don't take it personally! Warren Buffett has always referred to Mr Market as crazy and it can be overly stingy at times and overly generous at other times. Over a longer period of time, it should neutralize. The important thing is to get the fuel you want at the time you want it – so that you can focus on the only real thing that matters – building a real business!
What do you think?