Introduction
Valuation adjustments are an important part of the startup funding process. When investors provide capital to a startup, they want to ensure that the valuation and price per share they are paying accurately reflects the current status and future potential of the company.
Several factors may cause the fair market value of a startup to differ from its intrinsic or inherent value. Valuation adjustments are quantitative methods to account for these factors and “adjust” the valuation accordingly.
Some key reasons valuation adjustments are critical for startups:
- Early-stage startups have high risks and uncertainties. Valuation adjustments help account for these risks.
- Startups often lack governance controls. Valuation adjustments can help compensate for potential dilution or lack of shareholder rights.
- Investor liquidation preferences and other rights can significantly impact share value. Adjustments price these rights.
- Startups tend to burn capital and may require future financing. Valuation adjustments account for potential impacts of future fundraising.
- Market volatility means startup valuations can change quickly. Adjustments help smooth out temporary market swings.
As we’ll explore in this article, valuation adjustments provide a way to carefully analyze the specific circumstances of a startup and systematically modify its valuation based on objective factors. For startups seeking funding, valuation adjustments are a key tool to arrive at a fair valuation acceptable to both entrepreneurs and investors.
Common Valuation Adjustments
When valuing early-stage technology startups, investors often apply valuation adjustments to account for the higher risks and uncertainties compared to mature public companies. Two of the most common types of valuation adjustments are:
Discount for Lack of Marketability (DLOM)
The DLOM applies a discount to the estimated fair market value of the startup to account for the lack of liquidity. Since startups are privately held, their shares cannot be quickly sold on public markets like stocks of listed companies. This makes the shares illiquid and riskier for investors.
The DLOM discount typically ranges from 10% to 50%, depending on factors like the company’s stage of growth, profitability, time to exit event, and more. For example, a pre-revenue startup may warrant a 50% DLOM, while a late-stage startup nearing an IPO may only apply a 10-20% discount. The DLOM mathematically reduces the valuation to compensate investors for the increased risks due to illiquidity.
There are various methods used to calculate the DLOM, both quantitative (e.g. put option models) and qualitative (surveys, restricted stock studies, dividend yields). The most common approach compares the value of freely tradable stock vs restricted stock of public companies. Overall, the DLOM adjustment is highly subjective and company-specific.
Discount for Lack of Control (DLOC)
One common valuation adjustment for technology startups is the discount for lack of control (DLOC). This refers to a discount applied to the equity value to account for the lack of control held by minority shareholders.
As an early-stage startup begins raising investment rounds, the founders and management will likely maintain majority control while selling only a minority stake to outside investors. This means that these new minority investors have limited control and influence over business decisions. There is an inherent risk in owning a minority stake, as the investors must rely on the founders and management team to make sound decisions.
To account for this lack of control, investors will often negotiate a DLOC, reducing the nominal valuation of the startup. This adjustment helps compensate the investor for holding a minority position.
The DLOC percentage can vary substantially based on the startup specifics. Typically, the DLOC ranges from 10-30%, but can sometimes be higher for more mature startups. Factors like the concentration of equity control, Board seats allocated, shareholder rights, and degree of influence help determine the appropriate DLOC.
Overall, the DLOC adjustment helps address the valuation gap between a controlling and minority stake in an early-stage startup. It provides a risk premium for outside investors who have limited ability to direct the strategic decisions made by the founding team.
Future Dilution Adjustment
One of the most common valuation adjustments for early stage tech startups is accounting for future dilution of the founders’ ownership stake. This refers to the reduction in ownership percentage that happens when a company raises additional rounds of financing.
As startups grow, they typically bring on more investors in exchange for equity. For example, a founder who starts with 100% ownership will see their stake diluted to 80% after a Series A round, 60% after a Series B, and so on.
This matters for valuation because investors want to discount early stage valuations to account for the future dilution. The rationale is that a 20% stake today could get reduced to 10% or lower in the future as more shares are issued.
To calculate a future dilution adjustment, investors estimate the ownership percentage the founders are likely to have after future rounds of financing. This depends on factors like the industry, business model, and fundraising plans.
For example, if the founders currently own 60% but are likely to be diluted to 40% after the next round, the future dilution adjustment would be 1 – (40%/60%) = 33%. This percentage is deducted from early stage valuations to discount for dilution.
The adjustment helps balance the valuations by acknowledging the founders will own a smaller portion of the business in the future. Failing to account for dilution can inflate early valuations. The dilution adjustment provides a more realistic view.
Factors Influencing Valuation Adjustments
The stage of the startup is a key factor influencing the need for valuation adjustments. Early-stage startups tend to require more significant adjustments compared to later-stage companies.
a. Stage of Startup
Early-stage startups have a higher risk of failure and face more uncertainties in their growth trajectory. As a result, investors apply larger discounts to account for the risks. Pre-revenue or pre-product startups with no traction have the highest risk, necessitating the largest discounts.
As startups mature and reduce risk by hitting key milestones like product-market fit, initial revenue, and repeat customers, discounts applied by investors should decrease. Later-stage startups that are scaling rapidly with a proven business model require fewer adjustments.
The pace and sustainability of growth heavily influences valuations. Investors want to see strong signals that the startup can scale efficiently before removing discounts. Historical growth trends and projections need to demonstrate potential for maintaining high growth.
Startups should focus on derisking their business and demonstrating traction to minimize valuation adjustments. Reaching key milestones provides leverage during investment negotiations.
b. Investor rights/preferences
Investor rights and preferences have a significant influence on valuation adjustments for technology startups. Certain terms that investors negotiate can reduce the value of founders’ and employees’ shares relative to the new investors.
c. Liquidation preferences
Liquidation preferences give investors priority to receive proceeds in a liquidity event like an acquisition or IPO. A 1x liquidation preference means investors get their money back first before common shareholders receive anything. Higher multiples like 2x or 3x further reduce the amount distributed to common stock. This dilutes the value per share for founders and employees.
d. Participation rights
Participation rights allow investors to receive their liquidation preference first, then also share pro-rata in remaining proceeds. This amplifies the dilutive effect of liquidation preferences. Investors get paid back first, then continue to share in upside, leaving less for common shareholders.
e. Anti-dilution provisions
Full-ratchet anti-dilution protection reduces common shareholders’ ownership percentage if the company raises a down round at lower valuation. Weighted average anti-dilution formulas have a less dilutive effect but still reduce founders’ share value.
f. Redemption rights
Redemption rights give investors the option to demand repayment of their investment after a certain period if the company has not liquidated or gone public. This can pressure founders to sell or go public before they have optimized timing and value.
g. Voting control
Terms like super-voting rights and protective provisions give investors more control over major business decisions. This reduces founders’ decision-making power and control of the company’s destiny.
h. Market Volatility
The startup market is inherently volatile and can change rapidly based on macroeconomic conditions, industry trends, and company performance. As such, investors need to account for potential future dilution and down rounds when assessing current valuations.
During periods of high volatility such as recessions or industry downturns, investors typically apply larger valuation adjustments to account for increased risks. The same company could be valued significantly lower just a few months later if market conditions deteriorate.
Conversely, during bubbles and hype cycles valuations tend to overshoot and remain inflated for some time. However, these higher valuations are still premature and assume strong execution and growth. In these scenarios, investors make larger valuation adjustments to account for expected future corrections.
The level of adjustment depends on factors like the staging of capital, growth curve, macro conditions, and comps. Later stage startups tend to require smaller adjustments compared to pre-revenue or unproven business models valued purely on potential.
Overall, wise investors remain cautious during frothy markets and adjust valuations to build in margins of safety. This helps protect against likely future downward corrections as the startup will face the true market test over time.
Methods for Calculating Adjustments
Valuation adjustments can be calculated using both qualitative analysis and quantitative models.
i. Quantitative Models
Quantitative models take a data-driven approach to calculating valuation adjustments. Some common quantitative methods include:
- Option Pricing Model: This model treats future dilution events as call options that can decrease the value of existing shares. The Black-Scholes option pricing model can be used to quantify the impact. Key inputs include time to exit, volatility, and exercise price.
- Probability-Weighted Model: This estimates the probability of future dilution events based on comps. The weighted impact of dilution scenarios is calculated. More likely dilution events are weighted higher.
- Monte Carlo Simulation: This uses randomness and probability distributions to model a range of possible dilution scenarios. Running many simulations leads to a valuation adjustment distribution.
Quantitative models require estimates of future dilution levels and timing. However, they allow more precision in valuation adjustments vs. qualitative methods. The models help assess the mathematically fair discount needed to account for dilution risks.
ii. Qualitative Analysis
One method for calculating valuation adjustments is through qualitative analysis. This involves making judgment calls based on the startup’s specifics, rather than relying solely on quantitative formulas.
With qualitative analysis, investors will consider factors like:
- The startup’s business model and market potential
- Strength of the management team
- Product/service differentiation and competitiveness
- Development stage of technology or product
- Quality of IP and assets
- Fundraising track record
- Financial performance and metrics
- Macroeconomic conditions
- Exit opportunities
Based on an overall assessment, they will apply appropriate valuation adjustments. This allows for a more holistic approach, versus just mechanically plugging numbers into a formula.
Qualitative analysis combines both art and science. It relies on the experience and expertise of the investor to make informed decisions about the appropriate valuation adjustments. This process involves weighing all the positives and negatives for a given startup to arrive at fair valuations.
The downside is qualitative analysis can be prone to bias and subjectivity. Different investors may reach widely different valuation conclusions for the same company. There is no single right answer.
However, in the hands of a seasoned investor, qualitative analysis allows for nuanced judgment calls incorporating both quantitative data and qualitative insights. This can lead to more appropriate valuation adjustments than relying purely on formulas.
Case Studies
India has seen a surge of startup unicorns over the past decade, with major companies like Flipkart, Paytm, and Ola reaching billion-dollar valuations. However, arriving at these lofty valuations has involved careful analysis and adjustments by investors. Here are some examples of notable valuation adjustments for major Indian startups:
i. Flipkart
Flipkart is India’s largest ecommerce marketplace and one of its biggest startup success stories. When Walmart acquired a majority stake in Flipkart in 2018, it had to apply a discount for lack of control as it was not acquiring the company outright. This led to a reported 10-20% valuation haircut.
ii. Ola
Ola, India’s largest ride-hailing app, underwent significant valuation adjustments during multiple funding rounds. In 2015, a down round led by Softbank applied a 40% illiquidity discount due to unfavorable market conditions. In 2019, another round by Hyundai and Kia valued Ola at only 80% of its previous round.
iii. Paytm
During Ant Financial’s 2015 investment in Paytm, the mobile payments startup took a 20-25% valuation haircut to account for dilution of shares. When Berkshire Hathaway invested in 2018, it similarly applied a 10% DLOC discount. Paytm’s weak profitability metrics have led to recurring valuation markdowns.
iv. Zomato
Food delivery startup Zomato saw its valuation sliced by 40% in 2016 by its investor Vostok due to decelerating growth. Info Edge’s markdown of its Zomato stake in 2017 further dropped its valuation by 50%. However, Zomato managed to recover and hit $5 billion valuation prior to IPO.
v. Snapdeal
Online marketplace Snapdeal reached lofty $6.5 billion valuation in 2016. However, markdowns by Ontario Teachers’ Pension Plan and BlackRock cut its valuation by over 60%. Exiting investors were willing to take haircuts to allow fresh capital by Softbank to revive Snapdeal.
