Start-ups are an integral part of a developing economy like India. The Government of India’s start-up scheme which offers tax incentives to eligible start-ups is a testimony of the same. Often, there is a curiosity about which entities are eligible to be called as start-ups. As per DIPP notification, an entity shall cease to be a start-up on completion of ten years from the date of its corporation/registration or if its turnover for any previous year exceeds one hundred crore rupees. The start-up should be working towards innovation/ improvement of existing products, services, and processes and should have the potential to generate employment/ create wealth. An entity formed by splitting up or reconstruction of an existing business shall not be considered a start-up.
Start-ups in the real estate sector mainly represent prop-tech wherein a private company is involved in innovating a product or service using technology. Prop-tech has started to disrupt like never and as a result, new prop-tech companies are emerging which are using technologies such as IoT, artificial intelligence, edge computing, virtual reality, and data analytics, etc. Primarily, prop-tech companies can be broadly classified into three categories such as:
(a) Real estate Fintech, which supports real estate capital market
(b) Smart real estate or smart buildings, involving construction technology for operation and management of real estate assets
(c) Shared economy, in the form of a technology-based platform for facilitating the use of the real estate asset
Some of the prop-tech companies have managed to ride along the growth curve starting from pre-seed, seed to subsequent funding stage signifying scalability and maturity of the business. In the past, a handful of M&A transactions have also happened in the prop-tech sector. Valuation of the prop-tech company is therefore required at each stage of funding and during the M&A process.
Prop-tech start-ups do not have profit, and sometimes no revenue until their product or service is established in the market. Therefore, the valuation of such entities becomes a top-down approach and effectively depends upon various factors as mentioned below but not limited to:
(a) Track record of the promoter or co-founders (intellectual capability) and the reputation/goodwill of the team to run a successful venture
(b) Assessment of the customer or subscriber base and the growth velocity as compared to the competition
(c) Successful testing of the prototype, whether proof of concept exists
(d) Visibility of revenue, the sustainability of the revenue model
(e) The uniqueness of the idea, whether difficult to replicate
Considering the above-mentioned factors, there can be multiple approaches to the valuation of such prop-tech start-ups. Popular valuation approaches which investors apply are:
- Berkus Method: It was developed in the mid-1990s by angel investor Dave Berkus. This method assigns a range of values towards major risk elements faced by early-stage start-ups more likely the technology risk, execution risk, market risk, production/development risk. For the soundness of the start-up idea USD 0.5 million value is assigned and this value is boosted by USD 0.5 million if it addresses each of the remaining four risk factors. Therefore, the maximum valuation of a prop-tech start-up can achieve in this method is USD 2.5 million.
- Scorecard Method: This method is usually used to value pre-revenue start-ups by comparing it with the average pre-revenue valuation of other start-ups in the target segment. A scorecard (percent wise rating on various factors relating to risk and reward) is developed. Finally, the industry average pre-revenue valuation is multiplied to the sum of the scores to estimate the subject start-ups pre-revenue valuation.
- Discounted Cash Flow Method: The cash flow forecast of the start-up is discounted by the appropriate discount rate (expected return) to estimate the present value. In the case of a start-up in the pre-revenue stage, cash flows are normalized basis the stage of the life cycle of the business.
Sometimes, best case, normal case, and worst-case valuations are also assessed factoring the probability of the occurrence of such scenarios with the DCF values. Such type of valuation method is known as the First Chicago Method which was developed by the VC arm of the First Chicago Bank.
- Venture Capital Method: This method is also used for pre-revenue valuation of pre-revenue start-ups. It is based on investors’ anticipation of the terminal value of the start-up after a certain year. Based on the expected return, the current value is decided which is subject to adjustments for dilution and future rounds of funding until the sale occurs. Therefore, post-money valuation is derived by dividing the terminal value with ROI. Pre-money valuation is thus derived by subtracting the future rounds of funding from the post-money valuation.
- Multiples Method: This can be applied either on revenue or profit. Whether 3X multiple or 5X multiple or 10X multiple of the revenue or profit shall depend upon the factors such as credibility of the promoter and the team, sustainability of the idea, size of the market, etc. This method is however applicable for the companies which have crossed seed-stage and in growth stage generating revenue and profit.
Prop-tech start-ups are commonly targeting the property brokerage platform. Such property marketplaces space seems to be overcrowded with many start-ups trying to demonstrate their uniqueness to investors. These prop-tech start-ups are getting funding from hedge funds, pension funds, VC firms which are in the quest for mature business models to evolve. Thus, consolidation activity is expected to continue in this space.