Fundraising valuations are the process of computing the company’s value in monetary terms before and after a new investment round. It establishes a fair price of shares for Investors considering the potential growth of the company, risk profile, and market conditions using valuation methods like(discount cash flow(DCF) analysis, comparable company analysis, and precedent transaction analysis.
Its main purpose is to determine a price for a company’s shares during a fundraising activity, helping investors know the potential return they can earn on their investment while raising suitable capital for the company.
Role of Investment Banks
Investment banks act as Strategic partners during the fundraising process, making sure that a company’s capital-raising initiatives get the most in terms of both structure and valuation.
Helps in setting the Right Price: They advise on the valuation method that is apt for capturing the company’s worth to attract investors for it.
Structuring Deals: They create a fundraising deal that is aligned with the market standards and the company’s objectives, and negotiate for conditions that will benefit both the business and the investors.
Verification of Financials: They design models that estimate future performance and look at the company’s financial data.
Managing of IPOs: They control pricing and lead the business through its initial public offering.
There are some important concepts to know before getting into methods to calculate the valuation of a company:
- Pre-Money Valuation: It is the worth of a company before it gets investment from outside. It is useful to ascertain the ownership share for investors and the value of per-share.
- Post-Money Valuation: It is the estimated value of the company after receiving funding from investors. It is a critical indicator of a company’s worth after investment is raised and influences its investment strategies and aspects of startup financing.
Post-Money Valuation = Pre-Money Valuation+ Investment Amount
- Dilution: It is the decrease in the ownership percentage of existing shareholders as a result of new shares issued during the fundraising process.
Valuation methods:
Discounted Cash Flow(DCF) analysis:
It estimates the value of an investment based on the company’s expected future cash flows, using a discount rate(weighted average cost of capital) to reach the present value/fair value.
If the DCF value comes at a higher price than the cost incurred by the investor then this opportunity could be beneficial for generating returns.
A flaw of this method is that it is based on estimations, which could sometimes prove inaccurate due to unforeseen market conditions.
Steps to calculate the value of a company using DCF:
Step 1: Estimate the Free Cash Flows
We need to forecast the cash flows for the next stable years, which generally range from 5-10 years.
FCF is the money a company has left after covering its operating costs and maintaining its assets.
It is calculated as:
FCF=Net Operating Profit after Tax(NOPAT)+ Depreciation & Amortization + changes in working capital – Capital Expenditure
Step 2: Calculation of WACC(Discount rate)
It is the average return an investment is required to generate for the investors(both debt and equity).
The components of WACC are as follows,
Cost of Equity(Re): return required by shareholders calculated using Capital Asset Pricing Model(CAPM)
Re = Rf + β(Rm – Rf)
where Rf(Risk-Free Rate) generally equals the yield on government bonds.
β(beta): measure the volatility of a stock compared to the market.
(Rm – Rf)Market Risk Premium: expected market return over the risk-free rate.
Cost of Debt(Rd): interest rate a company pays on its debt.
It is adjusted for tax benefits (interest expenses are tax-deductible):
Rd * (1 – Tax Rate)
Capital Structure weightage
Equity Weight (E/V): percentage of total capital from Equity.
Debt Weight (D/V): percentage of total capital from Debt.
V(Total Capital) = E + D (sum of Debt and Equity)
Final WACC Formula:
WACC = (E/V * Re) + (D/V * Rd * (1 – Tax Rate)
Step 3: Calculation of Terminal Value
Terminal value shows the value of the company’s cash flows beyond the selected forecast period up to perpetuity. It captures the future cash flows that occur beyond the forecast period. It is calculated using the
Final year(year 5 in case of a 5-year forecast period) FCF, WACC, and a growth rate.
Step 4: Discounting of Cash Flows to Present Value
Each year’s FCF and the Terminal Value are discounted using WACC to show today’s value.
The sum of these discounted values gives the Enterprise Value(EV).
Step 5: Calculation of Equity Value and Share Price
(Market Cap)Equity Value= Enterprise Value – Net Debt(Net Debt = Total Debt – Cash)
Share Price= Equity Value / Total shares outstanding(including stock options and warrants)
Comparable Company Analysis( Comp Analysis):
It is a relative valuation method used to ascertain a company’s value by comparing it to its peers in the same industry.
The steps to conduct a Comparable Company Analysis are as follows:
Step 1: Identification of Comparable Companies
To identify suitable companies for analysis, we need to look for businesses having the characteristics as stated below:
- Same Industry/Sector
- Market Cap, Revenue, and Total Assets.
- Growth rate (similar profit growth rates)
- Comparable Profitability Margins
Step 2: Collection of Financial Data
After selecting a peer company for comparison, we need to gather financial information from various sources:
Such as Financial statements, Earnings Reports, and Analyst Reports for key financial metrics such as
Revenue, EBITDA, Net Income, Total Debt &Cash, Market Capitalization of the peer company.
Step 3: Calculation of Valuation Multiples
Key valuation multiples which are commonly used to compare companies irrespective of their size are:
Enterprise Value(EV) Multiples preferred for valuation:
- EV/Revenue- shows how much investors’ money is used for generating each unit of revenue.
- EV/EBITDA- helps in comparing companies on their operational efficiency, excluding costs that differ by capital structure.
- EV/EBIT- shows the amount being paid for the company’s core profit.
It considers both Debt and Equity, thus helping in comparing companies with different capital structures.
Equity Value Multiples (Public market comparisons)
- P/E (Price-to-Earnings): This ratio shows the willingness of investors to pay for each unit of income generated. A common approach to evaluate whether a stock is Undervalued or overvalued.
P/E= Stock Price/ Earnings per Share(EPS)
- P/E (Price-to-Book): This ratio compares the Market cap of the Company to its actual book value(net assets). Mainly useful for comparing companies in capital-intensive industries
P/E = Market Capitalization/Book value of Equity
Usually suits best for companies with Stable earnings, to provide a clear picture of what the market is rewarding to its investors.
Step 4: Application of Multiples to the Target Company
Once comparable company multiples are computed, deploy them to the target company financials to evaluate its value.
For example:
- If a peer company trades at an EV/EBITDA multiple of 20x and the target company’s EBITDA is ₹5 crores, the estimated Enterprise Value is EV= 20 * 5 crores= ₹100 crores
- If the net debt of 20 crores is there, then the Equity Value of Target company stands at 100 – 20 = ₹80 crores.
- Accordingly, the share price of the company can be calculated, say the number of outstanding shares is 5 lakh. Thus, the share price will be 80 crores/ 5 lakh shares = ₹1600
Step 5: Interpretation of Results and Make Adjustments
If the target company’s valuation is lower than its peers, it may be undervalued and offer a good opportunity to buy. Else, there is a potential risk (overvalued).
Adjust for Company-specific factors such as Growth potential, quality of management, and competitive advantage.
Comparable Company Analysis shows Real-time market sentiment and is widely used by investment banks, analysts, and private equity firms. But there is no existence of Perfect Comparables (Every Company is different on its own), making it difficult to compare.
Precedent Transaction Analysis(M&A comps):
It is a valuation method that uses the data of past mergers and acquisitions (M&A) transactions as a benchmark for estimating the fair value of the target company.
The steps to conduct a Precedent Transaction Analysis are as follows:
Step 1: Identification of Comparable Transactions
- Firstly, we need to look for past M&A deals in the same industry, geography, and business models as the selected target company.
- then, we will consider transactions of companies with similar size, profitability, and growth potential.
- we can get data from M&A databases available on sites like Bloomberg, Capital IQ, Pitchbook, company filings, and press releases.
For example, if we are valuing HUL(FMCG), we need to check M&A deals involving competitors like ITC Ltd., and Nestle.
Step 2: Collection of Financial Details of the deal
For each transaction, we need to collect,
- Purchase Price or Deal value: Total amount paid for the deal.
- Revenue& EBITDA of the acquired Company: Financial performance metrics of the acquired company.
- Enterprise value of the company at the time of Acquisition: total valuation including debt and cash adjustments.
- Amount of Premium Paid over Market Price: Extra percentage paid over the Pre-deal share price.
For example, If ITC acquires a company for ₹5000 Cr, and the Acquired company had an EBITDA of ₹1000 Cr, then:
EV/ EBITDA = 5000/1000 = 5x
Step 3: Calculation of Valuation Multiples
Key Multiples are as follows:
- EV/Revenue: It shows the amount paid per unit of revenue; useful in High-growth companies’ valuation.
- EV/EBITDA: It helps in assessing operating performance.
- P/E ratio: Purchase price/ EPS (handy when valuing Public Companies.
- Premium paid: It indicates the extra premium paid over the market price.
Premium Paid= (Offer Price- Pre-deal Share Price)/ Pre-deal Share price
For Example, If past deals in the FMCG sector present an average EV/EBITDA of 10x, we can use that as a benchmark for valuing ITC Ltd.
Step 4: Application of Multiples to the Target Company
We need to use the average multiples derived from past transactions to calculate the target company’s valuation.
For example, if the average EV/EBITDA multiple is 10x and HUL’s EBITDA is ₹20000 Cr, then:
Estimated EV = 20000 * 10= ₹2,00,000 Cr.
Step 5: Adjustment of Market Conditions and Synergies
we need to consider the factors in the current economic conditions, trends in the industry, and any synergy or Strategic benefits that were there at the time of past transactions.
Adjust the multiples if there are noteworthy differences, such as economic recession, or any policy changes that might affect the valuation of the company.
Precedent Transaction Analysis(M&A comps) takes into account what buyers are willing to pay and helps in the estimation of a fair price for acquisition targets. Meanwhile, For strategic reasons, buyers may pay higher premiums which gives a wrong valuation of the Target Company.
Venture Capital Method
It is a valuation process that is used to assess the worth of emerging, high-growth companies like startups, by determining their Sale value at a forecasted future date and then discounting it to the present using an expected rate of return in consideration with the associated high risk. It computes the value an investor should pay today based on prospective future gains when it is going Public or acquired.
The steps to compute the value using this method are as follows:
Step 1: Estimation of Exit Value(Future Value)
In this, we determine the anticipated exit value derived from forecasted revenue, earnings, or market comparables.
Step 2: Establishment of the Target Return(Discount Rate)
In this investors need to set a required Return rate based on their risk appetite.
Step 3: Calculation of Post-Money Valuation(PMV):
By using the formula,
Post-Money Valuation = Exit Value / (1+ r)^t
where, r= required rate
t= no. of years until exit
Step 4: Determination of Pre-Money Valuation(PMV):
We need to deduct the amount of Planned investment from the post-money valuation
Pre-Money Valuation = Post-Money Valuation – Investment
Step 5: Calculation of Investor Ownership Percentage
Ownership percentage required = Investment / Post-Money Valuation
This evaluates the part of ownership in the company an investor receives.
For example, A venture capitalist wants a 40% return per year. He is valuing a startup company named ABC.
- Company ABC is projected to sell for ₹5 Cr in 5 years.
- using the PMV formula,
PMV= 5Cr / (1.4)^5 = 5 Cr / 5.38 = 92.9 lacs
- If the VC invests 30 lacs, then:
Pre-Money Valuation = PMV – Investment = 92.9 lacs – 30 lacs = 62.9 lacs.
- Ownership percentage required = 30 lacs / 92.9 lacs = 32.3%, VC gets 32.3% stake in the ABC company.
Book Value or Asset-Based Valuation
It is used to determine the net asset value(NAV) of a business by examining the company’s balance sheet.
NAV = Total Assets – Total Liabilities
This method is useful for Asset-intensive businesses(Manufacturing and real estate industry) or bankrupt businesses where the assets are auctioned for sale. While it is complicated for intangible asset evaluation and requires a fair market value of a business.
For example, a manufacturing company XYZ is being valued on its assets:
- Total Assets= 95 lacs
- Total Liabilities= 30 lacs
- NAV= 95 lacs – 30 lacs = 65 lacs
- If in case XYZ gets liquidated, Assets may need to be sold at a discounted rate( say, 20% disc)
Liquidation value = 95 lacs * 0.8 = 76 lacs
New NAV, 76 lacs – 30 lacs = 46 lacs
So, the company is worth 65 lacs if it exists as a going concern and 46 lacs if it gets liquidated due to bankruptcy.
Key Factors Influencing the Fundraising Valuations:
- Revenue and Profitability of a company: Investors look at earnings, Profit margins, and EBITDA to evaluate a company’s financial condition.
- Market circumstances: Economic trends, industry cycles, and investor mood can drive valuations to go upside or downside.
- Growth Potential of the company: companies that show rapid growth in revenue and customers, especially startups often get higher valuations.
- Competitive landscape in the industry: Businesses with unique business models, intellectual property, or a strong brand can enjoy a boost in value setting them apart from competitors.
- Investor Demand and Liquidity: Investors’ interest and availability of free capital leads to higher valuations, However, lower liquidity and interest tend to more conservative pricing.
Fundraising Rounds and their impact on Valuation and Ownership Structure
- Seed Round: It is the very first stage of funding that usually comes from angel investors or seed funds. The Venture Capital Method is often used for valuing to estimate the future worth of a company based on its potential growth.
- Series A: In this early stage, venture capitalists help a business grow beyond its initial phase. CCA, DCF, or the VC method are used to value companies considering the peer companies, future earnings, and growth prospects to determine a fair value.
- Series B & C: These are the final-phase rounds that focus on scaling operations, market reach expansion, or new product development. Valuations at this stage are often done using the CCA method using Revenue Multiples( comparing the company’s revenue to Industry standards and other benchmarks to help investors see how the company stock performs compared to its peers.
- Pre-IPO and IPO Valuation: These are the final stages before and during the company going public. In this stage, Investment bankers play an important role in setting the IPO price and use a process called book-building to determine the final valuation.
Conclusion
A company’s value is established by fundraising valuations, which act as an aid for capital-raising and choosing investments. Financials, trends in the market, and growth potential are the starting point of assessing value using techniques such as DCF, CCA, Asset-Based Valuation, VC Method, and Precedent Transactions. Investment banks are crucial in IPO management, pricing, and deal structuring. Investors and founders can make wiser choices if they have a solid understanding of valuation concepts. Long-term company growth is backed and investors are drawn in by a well-calculated valuation. A well-calculated valuation attracts investors and supports long-term business growth.
FAQ’s
What are the most used Methods for Valuation?
Discounted Cash Flow(DCF)analysis, Comparable Company Analysis, and The Venture Capital method are the frequently used methods of Valuation.
What method is suitable for Startup Companies Valuation?
The Venture Capital method is often used for Startups, as it focuses on the future growth potential and sale value.
Why ownership stake of the founders of a startup company reduced after the Fundraising process?
The founders wanted to raise capital for the expansion of the business for which they needed to share some proportion of their own share in the company to the investor to get money and some expertise from experienced business leaders in the industry.
When to Buy a Business?
After determining the valuation of a business, if its intrinsic or fair value comes more than the market value of similar businesses in the industry, then the business is undervalued and there is growth potential. Therefore, the Business should be bought at an unvalued price.
Can Fundraising valuation change after investment?
Yes, the changes in financial performance, market conditions, and unsystematic business risk(impacts specific companies) can impact valuation over time.
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