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The true value of Indian unicorns

( 15:00, 28-Apr-16)

Investments in start-ups come attached with downside protection clauses, which are like a put option written by existing investors in favour of new investors 

report in Mint earlier this month mentioned that Indian e-commerce firms Flipkart and Snapdeal have hit a “valuation wall”, with prospective investors unwilling to meet their latest headline valuations of $15.2 billion and $6.5 billion, respectively. This followed moves by T Rowe Price and Morgan Stanley in marking down the valuation of Flipkart to $12.75 billion and $11 billion respectively in their investor declarations.

Taken together, this possibly suggests that these e-commerce biggies might be in trouble, and possibly unable to compete with the Indian arm of Inc. While that is a plausible conclusion, there is another factor that might explain both the valuation discount and companies’ unwillingness to raise money at lower valuations—the optionality granted to investors.

When an investor invests Rs.1 crore for a 10% stake in a start-up, it is a common practice to assume that this investment values the start-up at Rs.10 crore. While this is intuitive and arithmetically sound, the problem is that it ignores the optionality that is inherent in any start-up investment.

Given the risks associated with investing in a start-up, investors usually demand some downside protection. While this downside protection comes in various forms, one of the most popular (and simple to understand) structures is called the “full ratchet”. According to this, existing investors in a company (this usually includes the founders) underwrite the new investor’s investment, and agree to fully compensate the new investor in case of a subsequent fall in the company’s valuation.

Let us assume that company XYZ raises Rs.1 crore from an investor, Alpha Partners, in exchange for a 10% stake. This investment gives XYZ a “pre-money” (excluding the fresh investment) valuation of Rs.9 crore, and a “post-money” (including the investment ) valuation of Rs.10 crore. Let’s say that a few months down the line, XYZ hasn’t done as well as expected, but needs fresh funds, which Beta Partners agrees to provide. Beta, however, insists on a pre-money valuation of Rs.8 crore.

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