 Namaskar, I'm Professor Devdeep Purkayastha from the Indian Institute of Technology, Bombay. Welcome to my course, Business Fundamental for Entrepreneurs Part 1, Internal Operations. As part of the course, I'm very pleased to welcome Professor Umakan Jayaram, who is a very illustrious finance industry veteran to share a few modules. Professor Umakanth is an alum of IIT Bombay, and he went on to do his MBA, post which he has 30 years plus of industry experience in various aspects of finance. He has worked extensively in the banking industry, he has founded his own company, he has sold his own company, and he serves now as a public interest board member at the Bombay Stock Exchange. So it is my pleasure to hand over to Professor Umakanth for his module. So while valuation of a mature business is determined by the cash flows and the discounted cash flows, at least the intrinsic value, and then of course the price process basically kicks in, basically on the value of the business. The question being asked is, how do I value a business which is a startup, which is yet to get its first rupee or dollar revenue? In order to answer the question, we basically need to know a little bit about what are the kind of people who invest in pre-revenue stages of startup. This table shows you the sources, the purpose, and the stage in which certain investors enter their investments, and for what level of ticket size and what stakes do they actually invest. So if you're a startup which is having a proof of concept, an idea which is POC, you probably would just bootstrap it to yourself, that expenditure is taken care of by yourself, and your friends, family, and what is known as fools, but okay let's not call it fools. The objective of this phase is to convert your idea into some kind of POC concept. It could be a prototype, or it could be a service proof of concept. You only seek external funds after this stage, and usually the external funds that you actually seek comes as a twin objective. Your funds come in because you need it, but more importantly you've got to see it as dilution of control, and whether that's a cost that you are actually willing to take, and how much can you willing to give out in form of equity control. There are very many startups where the founders are more sensitive to the amount of control they want to actually have on the progress of their business. And in either case, founders will be well advised to actually introduce people into the ownership team only based on how they can add value at this stage, not on the amount of finance they can bring in. So angels are basically people who have already done this business, or some of the business have been through a startup cycle, and understand the pains of starting up, understand the joy of a startup, understand the kind of payoffs that come from a successful startup. To a very large extent, they come in with a huge value proposition of guidance, mentorship, and actually networking, and this is actually the reason why many founders introduce their plans to angels at this stage. When they have a prototype, they want to speak some amount of funds, they want to bring in more credibility to the ownership team, and network a little bit better for future funding rounds. Subsequently, or alternatively, they could also have institutional grants or incubator funds that can actually help them do some a little larger investment, and also in a coordinated way where more than funds, they actually have a facility of hosting their startup business in an environment where further progress on the product development is possible, to the point that they can complete a minimum value proposition and also test it out in the market. They only introduce institutionals at the early stage, pre-revenue stage, such as venture capitalist, only after having completed these three major stages. Venture capitalist are very comfortable when some history has been transpired in their business, in actually giving fruition to the business plan, an MVP completed, some customer prospects sounded out, validation being done, a market fit having been achieved, and a prototype being done. This is the stage that we're going to be talking about as to how pre-revenue valuations will determine the capitalization of startups. Again, we actually covered the concept, the technology, the launch and stage, and wherein we start looking at seed VCs. VCs generally are good for up to five million dollars usually, but sometimes even more than that when it comes to early traction with revenues and so on of investments. There are two methods in which pre-revenue valuations can be done, which I'm going to share with you today. There are many more than that, of course, because the Burkus method exists, but usually all of these are scorecard methods. The fact remains that most early startups, they break a bet on the team, the founding team. What they're looking at the team is whether they have the right level of skills, the right level of emotional intelligence working in teams and complimenting each other with their skills, have a good listening sense and learning mindset, and people that they can otherwise get along with. Effective teams who have done this before are, of course, always having an advantage in raising new rounds for new monies. So team is coming first. The second thing that early stage investors VCs look at in startup prospects is the market opportunity. What is the business plan aiming to achieve? Is this a scalable business? It's important to know that not all startups are amenable for VC investments. There are businesses which are called lifestyle businesses, which essentially have a profile such as this. They don't probably spend too much money in the beginning, but they take a long time to actually recoup their investments. They are controlled by the promoters, and promoters have a big say in all the decision making throughout. VCs are more interested in if need be, bigger investments begin with, but most importantly there should be a steep growth, exponential growth afterwards. This is the difference. And therefore not all businesses have that same sign of scalability, sustainability, and huge exponential opportunity. They only look at those opportunities. And finally, they also look at what is your achievement path so far and what is the path to profitability. If all of this are within a scope of a conversation, then VCs will actually come up and say, okay, I'm good for this kind of value if you want so much money for your business. Usually they will ask for 26% and above, 30% stake in their startup, because they need to actually control the further capitalization, or at least have a say in the further capitalization table progress, which is why most VCs will actually look at the capitalization history as well, and make sure A it is clean, and second, there is enough room for them and others to, series A, series B, series C rounds to take place. So assume that you need about a million dollars of external cash, and you're willing to give 30%. So state on pre-money valuation, a million dollars that you invest for what you think is the value of your business, will be determined by a bilateral discussion between you and the VC. Let's assume that you look at the business as a pre-money valuation, as a valuation without the money coming in at 4 million, and after the money comes in at 1 million, it goes up to 5 million. If the business is valued at 4 million, or 30% stake of that business would be about 1.2 million, and you'll be retained with 2.8 million dollars worth of the business. This is roughly the amount that you'll raise from the round. Now what the VCs will really want at the back of the mind, and they'll be testing based on their own due diligence, on the team, the market opportunity, the actual capitalization history, the prospects for growth, and whether their part of profitability will be achieved through a reasonably credible plan, as to how much they can actually take the valuation from what it's grown pre-money at formal, to in 3 years or 5 years time, to approximately 100 million dollars. This is a 20-fold expansion in valuation. This is what VCs look for. And if they achieve that, then if you back-calculate their own portion of 200 million would be worth 5 million, they're invested 1 million, so that's a 5-time increase for themselves. And this is exactly what the kind of multiples and the kind of returns that VCs look. They obviously don't make it in all prospects, they do make it in few, and where they really make the money, they can actually recope the losses in others. This is known as the VC method. Besides the VC method, you also have the scorecard method which grant institutions and other incubators will look at before you go to the VC, and they basically scorecard you on various criteria such as the team, the size of the opportunity, the product and the technology that you're building at, whether it is having any technology risk or whether it's an upside, whether it's a competitive environment for your products and services, the kind of sales and marketing skills that you have in place or can gather over the next 3-4 years, the financing that you require to fulfill your plans and other such factors. And they score you in a scale of 1 to 5 with some weights in it. And the sum of all these factors with a benchmark for all the kind of other prospects which have got funded is the basis for whether your proposal will get funding or not. This is how pre-money works. One is by you taking a decision as to how much your valuation is going to be and how much funds you require from an external VC, and VC taking decision based on your decisions as to whether he can make a reasonable multiple on his own analysis of your prospective plan, the funding team, the execution capability and the operating profitability metrics. And if that can be translated to a 20 times return, then he will be actually taking a risk on you. This is how non-revenue based investments in the VC based world works. I'm going to end my entire session on finance with this last topic which is non-revenue valuation. But important to know that even the VCs depend eventually on the end state stable, sustainable, intrinsic value which is determined by discounted cash flow in the long run. And such will be the nature of the play bloke that they will be waiting for some more years till your business becomes very stable and earns the kind of valuations they're seeking for. In summary, to reiterate the venture capital method, once you present to the venture capitalists, you as the founder or the owner, as to how much money you want to raise in this round, in this case $1 million, and how much actually you're willing to actually give up in form of equity control, in this case 30%. The venture capital goes back and does a due diligence and analysis as to whether your current funding needs based on is actually going to be justified when he actually does a due diligence on your market opportunity, your business plan, the ability of exploiting extraordinary profits at a later stage, and exploiting exponential returns, and with the kind of risk that he's willing to take on your execution capability. He's going to make a call as to whether he can actually grow his investment 24 in five years. So, a 24 increase of a $5 million investment that he's putting in post his $1 million really translates to $100 million value, and that is the journey that he's going to share with you to actually grow the firm from what it was as a $2.8 million opportunity or $4 million opportunity to a $100 million opportunity, and this valuation will be tested by further rounds that he can raise from the follow on investors in series A, series B, and series C. So, the venture capital method basically lists an early stage investing method where revenue is not established, but when revenue comes in and the business makes the turn from losses to profit and then starts experiencing exponential growth, he's already an investor and at least a 30% shareholder, and he participates in that growth. If he's convinced that such an opportunity is really going to be effectualized with you, he will actually make a term sheet with you. As to other opportunities where you can raise funds besides the venture capital business, such as the ones which are either lifestyle or the ones which is a pure technology play, which is a long gestation, you can look at grants and incubators and postpone your actual discussions with the VC at the later stage. Grants and incubators go by the scorecard method and they go by currency as to how many other equivalent startups with the same innovative position and the same kind of founding team and the same kind of business risk and probably the same kind of opportunity if not better have been funded in the past and what valuations did you assign to them? That will serve as a benchmark for some kind of evaluation that they will assign to you using the scorecard method. This in short summarizes the pre-revenue evaluations approaches and just one thing to be noted is although these investments have been made without any revenue in mind, eventually these investments will actually be tested for whether your business becomes sustainable and profitable in future with a good valuation. This intrinsic valuation eventually for a mature stage company is based again on the discounted cash flow technique. And as you would see in the slide, the last two stages are usually people who actually give money for growth equity and near pre-IPO and IPO investors. Both these investors really like to look at DCF or near DCF valuations to determine the intrinsic value of a business because they would expect to get in when there are already some cash flows being generated by your business. This concludes the finance modules of our course of entrepreneurship education for founders. I hope you found this useful. We covered finance as well as accounting. Thank you.