Arun Balakrishnan
Wednesday, December 30, 2009
Arriving at the valuation of an internet startup is considered as an art, which is perhaps the best mask for the cluelessness of an entrepreneur and the generalization done by investors. This labyrinth is a byproduct of varied subjectivity with a large focus on the qualitative rather than quantitative valuation methods like P/E comparable or discounted cash flow methods. The limited data available on comparable companies and industry benchmarks has only contributed towards the complexity. There also exists a significant amount of survivorship bias, which effectively ignores the results of Internet start-ups, which get shutdown. This problem gets further accentuated given the nascency of venture capital (VC) in India.

The off-shoot of this valuation mismatch has been the limited number of investments in seed stage and early stage ventures. Attributing the lack of pathbreaking products like Google, YouTube and Twitter from Indian entrepreneurs due to lack of creativity, would be a huge misnomer. The product development support for such ideas is missing from the Angel and VC fraternity of India. Thus, the divide that has been created, is because the risks of - venture capitalists not aligned with the valuation and capital expectations, of Indian entrepreneurs, who use their silicon valley counterparts as a benchmark.

Financial projections presented by entrepreneurs in India, are generally, a haphazard assortment of perceived expectations, irrational confidence, and market defiance and excel modeling of maybe about 2-3 hours. Therefore, besides the validation of common valuation variables, also significant adjustments have to be made to the valuation, keeping in mind the consumer behavior, Indian Internet industry and the Indian entrepreneur psyche. The value and weights of these adjustments depends on the impact they have on the business model and should be taken on venture to venture basis.

The primary task is to arrive at a base valuation of the start-up, which can be done through either the Terminal value method by Professor William Sahlman or the Probability Adjusted Present Value (PAPV) method. The effectiveness of the PAPV method in the Indian context is impugnable as both the volume of start-up investments and quality data available on them is low. In the terminal value method, usage of arbitrary assumptions for earnings multiple and P/E ratio can result in a value, which is discordant with the true value of the start-up. The P/E ratio of a comparable firm being used should be congruous with the stage of the life cycle of the internet start-up.

Positive Adjustments to the Valuation

Skills in the Management Team: The two skills, which are paramount to an internet start-up, are

1. Product Development
2. Sales

A founding team consisting of PhD and technical degrees from pedigree institutes ensures that the product development is in sync with the latest technological developments. The educational background can also be substituted with experience of at least 3-4 years in a large internet company. For sales, industry contacts are paramount and employees with relevant sales background in the industry contribute to the accelerated growth of revenues. In a nutshell, founding team of engineering graduates and acquired sales skill can be valued more than a founding team of management graduates and acquired product development skills.

R&D and stealth mode investments: Very few start-ups in India focus on good product development and testing in stealth mode before launch. The pressure from angel investors to launch as soon as possible also contributes significantly to the cause. So a start-up that has devoted time to research and product development should be given the due credit. Research is something, which has never been the focal point of businesses in India, and seldom have you come across a start-up in India akin to Mint.com, which was in stealth mode for a period of almost nine months for the alpha version launch and then another nine months for the beta launch.

Patent Protection capability: In case of product patents filed in India, the end product is patented and not the process for developing that product. Coupled with the weak Indian patent laws, it means that, an existing competitor can replicate the product with minor tweaks to the finished product. So a product with marginal innovation, but tougher replication process, has a competitive advantage over a highly innovative product with a reasonably easy replication process.

Entrepreneurs financial and time commitment: Culturally Indians are risk averse and an entrepreneur, who has shown the commitment to the venture by investing his own money as well as sweat equity should be duly compensated with a better valuation. A serial entrepreneur does come with its merits, but should be taken in the Indian context with a pinch of salt. Given the low capital requirement and ease of developing an internet product, lot of college students can boast of having run a start-up. Care should be taken in not overvaluing this experience.

Negative Adjustments to the Valuation

Customer Acquisition method: Contrary to belief about seven years ago, the customer acquisition cost through search engine and digital marketing with respect to the potential revenue per customer is very high in India. So any business, which is transaction oriented with high dependency on search engine traffic faces a huge risk if it does not have an inherent sticky factor. The travel websites like Makemytrip, Yatra and Cleartrip being the prime examples where the customer acquisition cost takes a significant chunk out of them, as such, wafer thin gross margins.

New Product New market: Blue ocean strategy in India makes up for only a good read, with most of the investments being in new products with existing markets. For good revolutionary products to be made the angel investors/venture capitalists should be willing to experiment with a new product and a new market. The risks associated with this are definitely high and the entrepreneur should be willing to settle for a lower valuation given the proportionately higher risk being borne by the investor.

Advertisements as primary source of revenue: A combination of factors like limited Internet population (81 Million), broadband penetration (5.3 Million) and low revenue potential per user, results in denying an Internet product - the requisite scale that it can become a multimillion dollar enterprise solely on advertisement revenues. The battle of monetizing the traffic is one, for which the top Internet sites of India fight everyday.

A paradigm shift in risk-return calculation, which factors in some demographic specific qualitative factors, is the need of the hour. If the above parameters are factored into the valuation, then the return expectation of an investor can surely be conciliated with the capital and valuation expectation of the entrepreneur. Without the collaborative effort of the investors and entrepreneurs, it will be difficult to “stumble upon” world class Internet products in the Indian entrepreneurial ecosystem.

The author is CEO & Founder, Fintact.com

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