Aswath Damodaran, Uber’s Valuation and Ratchets

The last time I’d written about Aswath Damodaran’s comments on Uber’s valuation, it was regarding his “fight” with Uber investor Bill Gurley, and whether his valuation was actually newsworthy.

Now, his latest valuation of Uber, which he concludes is worth about USD 28 Billion, has once again caught the attention of mainstream media, with Mint writing an editorial about it (Disclosure: I write regularly for Mint).

I continue to maintain that Damodaran’s latest valuation is also an academic exercise, and the first rule of valuation is that “valuation is always wrong”, and that we should ignore it.

However, in the context of my recent piece on investor protection clauses in venture investments (mainly ratchets), it is useful to look at Damodaran’s valuation of Uber, and how it compares to Uber’s valuation if we were to account for investor protection clauses.

“True value” of Indian unicorns after accounting for investor protection. Source: Mint

When Uber raised $3.5 Billion from Saudi Arabia’s Public Investment Fund earlier this year, the headline valuation number was $62.5 Billion. Given the late stage of investment, it is unlikely that the investor would have done so without sufficient downside protection – at the very least, they would want a “full ratchet” (if the next investment happens at a lower valuation, then they get additional shares to compensate for their loss). This is a conservative assumption since late stage (“pre-IPO”) investments usually have clauses more friendly to the investor, usually incorporating a minimum “guaranteed return”.

Plugging these numbers into the model I’ve built (pre-money valuation of $59 Billion and post-money valuation of $62.5 billion), the valuation of the put option written by existing investors in favour of Uber comes to around $1.28 Billion. Accounting for this option, the total value of the company comes out to $39.6 Billion.

Damodaran’s valuation, based on his views, principles and numbers, is $28 Billion. Assuming that investors and management of Uber are aware of the downside protection clauses and its impact on the company’s valuation, Damodaran’s valuation is not that much of a discount on Uber’s true valuation!

Private and public valuations

HSBC seems to have set a cat among the private market pigeons by recommending that Zomato’s “real valuation” is half of the stated headline valuation (my apologies for not “covering” Zomato in my piece on startup valuations two weeks back).

This was part of HSBC’s analyst report on InfoEdge (Naukri), which is Zomato’s largest investor. All possible parties concerned have hit back at HSBC for this valuation. Most of them (Sanjiv Bikhchandani (founder of InfoEdge), Zomato founder Deepinder Goyal, investor Sequoia, etc.) have been simply talking their book.

But you see several completely unrelated people in the Indian startup world commenting about HSBC’s valuation, including allegations that HSBC doesn’t understand how private companies are to be valued.

The interesting thing about this discussion is that you seldom see such debates about public companies. Nobody questions analyst reports of public companies on methodology. At worst, company PRs might issue statements challenging some of the assumptions that have gone into the analyst reports.

What differentiates public and private market analyst reports is the ability to trade – if you have a view on the valuation of a public company, it is rather easy for you to turn this view into a profit (with the risk of a loss) by trading on it. If you think a company is undervalued, you buy shares, and profit when its valuation corrects.

With private companies such as Zomato, on the other hand, there is no way for someone who is not already an investor to profit from their views on the company’s valuation. Shorting is out of the question. Even going long happens in different “series”, and is not a continuous process.

If Zomato were a public company, investors acting on HSBC’s report might have tried to push down the price of the stock, and the extent of money on the “other side” would have quickly shown whether HSBC’s view was correct. With the company being private, such objective means of agreeing on valuations don’t exist. And so concerned parties bicker.

To me, the most telling line in the Mint report on the spat between HSBC and InfoEdge is where they quote Bikhchandani.

“We value our investments at cost and Info Edge has not marked down Zomato at all,”said Bikhchandani.

Speaking of ostriches with their heads buried in the sand…

Valuing Global Fashion Group

Yesterday, in Mint, I wrote about ratchets in option valuation (a pet topic of mine), and gave alternate valuations of different Indian “unicorns” by accounting for the downside protection clauses that come with startup investment.

Money quote:

This implies that a share of the company held by [investors] includes a long put option, while a share of the company held by earlier investors includes a short put option (since they have implicitly written this option). In other words, a share held by the new investors is worth much more than a share held by earlier investors.

Now comes news that Global Fashion Group (that includes Jabong and a few other fashion houses started by Rocket Internet) has raised money at a “down round”. This gives me a good opportunity to put my theory to practice.

GFG has now raised $339M for a headline valuation of $1.13 billion. In its earlier round, it had raised $169M for a headline valuation of $3.5 billion. Let us look at a hypothetical employee of GFG who owned 0.1% of the company before the previous round of investment, and see what these shares are worth now.

Absence of ratchets

GFG had a “pre-money” valuation of $3.33 billion, and 0.1% of that would have been worth $3.33 million. As of that round of investment, existing investors had 95% stake in the company, so our friend’s share of the company would have come down to 0.095% (95% of 0.1%).

The new round shows a pre-money valuation of $791 million, and so our friend’s stock would be worth $750,000 after the latest round of valuation. This is a comedown from the previous valuation, but is still significant enough.

Presence of ratchets

Let’s assume that the previous round of investment into GFG came with a full ratchet (we’ll look at other downside protection instruments later). This would mean that its investors in that round would have to be compensated for the drop in valuation.

Investors in the previous round put in $169M for a headline valuation of $3.33Bn. The condition of the full ratchet is that is that if this round’s pre-money valuation were to be less than last round’s post-money valuation, the monetary value of last round’s investors has to be the same.

So despite this round showing a pre-money valuation of only $791M, last round’s investors would claim that $169M of that belongs to them (the way this is achieved in an accounting context is that the ratio in which their preferred shares convert to common shares changes). So the earlier investors (who came before last round) see the value of their shares go down to a paltry $622M. From owning 95% of the company, the down-round means they only own 79% now. And that is before the new round has come in.

Investors in the new round have put in $339M for a headline valuation of $1.13Bn, giving them a round 30% stake. Earlier investors have a 70% stake, of which investors who came before the previous round (which includes employees like our friend) have a 79% stake, giving them a net stake of 55%.

Coming back to our friend, remember that he owned 0.1% of the shares before the last round of investment. The ratchet means that he owns 0.1% of 55% of the company’s current headline valuation. This values his shares at $622,000.

But not so fast – since this assumes that the latest round of investment has no ratchets. If we need to take into consideration that this round has a full ratchet as well, the option formula I used in the Mint piece says that GFG is now worth $760M, far lower than the $1.13Bn headline valuation.

This implies that the stock held by investors prior to this round is now worth only $421M ($760M – $339M). Investors prior to the last round held 79% of these shares, so their stake is worth $331M now. Our friend held 0.1% of that, so his stake is only worth $331,000.

In other words, if both the previous and current rounds of investment in GFG came with a full ratchet protection, the shares held by ordinary investors such as our friend would have lost 56% of its value on account of optionality alone! Notwithstanding the fact that the remaining shares are held in a company whose value is on the downswing!

Then again, downside protection for investors could have come by other means, which were less harsh than full ratchet. Nevertheless, this can help illustrate how much of founders’ and employees’ shareholder value can be destroyed using ratchets!

Two way due diligence

In a cash-and-stock or all-stock acquisition, does due diligence take place one way or both ways?

This is a relevant question because not only are shareholders of the acquiring company acquiring shares of the target company, but shareholders of the target company are also acquiring shares of the acquiring company.

Take, for example, Foodpanda’s acquisition of Tastykhana in 2014. The source of this snippet, of course, is the brilliant Mint story about Foodpanda earlier this week.

Shachin Bharadwaj, founder of TastyKhana, a Pune-based start-up that Foodpanda acquired in November 2014. After spending two months inside the company, Bharadwaj was disturbed about the lack of processes and had uncovered several discrepancies—fake orders, fake restaurants, no automation, overdependence on open Excel sheets, which were prone to manipulation, and suspicion over contracts awarded to vendors.

“I know I am making allegations,” he told the people in the room. “All I am asking is that we do an independent audit.”

The others were not interested.

“The past is the past,” said Malhotra. “Let’s just resolve the differences and find a way forward for you and Rohit to work together.”

So Foodpanda acquired Tastykhana, and the Tastykhana founder (who became a Foodpanda employee) later found out that Foodpanda wasn’t the company he had assumed it was, and now owning shares of a company he had overestimated, he rightly felt shafted. It’s unlikely that due diligence happened “the other way” in this acquisition.

I had written on LinkedIn a while back about how employees accepting stock in a company that is hiring them are implicitly investing financially in the company, and that they need to be able to do due diligence before they make such an investment. Acquisition works in a similar way.

So I’m repeating myself yet again in this blog post, but is “reverse due diligence” (acquiree checking acquirer’s books) a standard practice in the M&A industry? Does this work differently in big company markets and in startups? Do acquirers get pissed off when acquirees want to do due diligence before getting acquired (when being paid in stock)?

Note that this doesn’t apply to all-cash deals.

Why Grofers is not a sustainable business

When I meet acquaintances for “gencus” nowadays, one of the things we somehow end up talking about is the startup world and inflated valuations of some Indian tech-enabled startups. The favourite whipping boys in any such discussions are food delivery companies such as Swiggy or TinyOwl and grocery delivery startups such as Grofers.

All three aforementioned companies have raised insane amounts of money and are making use of these insane amounts of money to poach employees at inflated valuations. They are also launching significant “above-the-line” advertising campaigns making use of the funds they are flush with. Yet, there is one fundamental concept that indicates that these companies are not likely to go far.

The whole idea of e-commerce is that you trade inventory costs for transportation costs. In “traditional” offline retail, transportation costs are low, since everything is transported in bulk, up until the retail store. In exchange for this, there are significant inventory costs, since inventory needs to be stored in a disaggregated fashion (at each retail outlet) pushing up uncertainty, and thus costs.

E-commerce works on the premise inventory is held in an aggregated fashion thus pushing costs down significantly (especially for “long tail” goods). In exchange, the entire transportation supply chain happens in an expensive “retail” manner. Thus, you save on inventory costs but incur transportation costs.

The problem with businesses such as Grofers is that they incur both costs. First of all, since they rely on picking up goods from retail stores, the high inventory cost is incurred (the hope is that retailers will give Grofers bulk discounts, but that is capped at a fraction of the margin that retailers make). And then, since Grofers transports the item to the customer’s location, retail transportation cost is incurred (whether it is directly paid for by the customer or by Grofers is moot here, since it has the same effect on prices and volumes). Thus, Grofers incurs costs of inefficiencies of both online and offline retail, and is thus a fundamentally unsustainable business.

It can be argued that Grofers offers a degree of convenience that you pay Grofers rather than incurring the cost yourself of getting the goods from the shop. This has two problems, though – firstly, a large number of small and medium retailers in India anyway offer free home delivery (and take orders by phone). Secondly, the cost incurred by Grofers for delivery is a transaction cost and irrespective of who bears it, it results in a reduction of total volume of transactions.

In its last round, Grofers raised $35M. Given the above fundamental inefficiency in its model, it is hard to see the business being worth that much in the long term.

Means, medians and power laws

Following the disbursement of Rs. 10 lakh by the Andhra Pradesh government for the family of each victim killed in the stampede on the Godavari last week, we did a small exercise to put a value on the life of an average Indian.

The exercise itself is rather simple – you divide India’s GDP by its population to get the average productivity (this comes out to Rs. 1 lakh). The average Indian is now 29 and expected to live to 66 (another 37 years). Assume a nominal GDP growth rate of 12%, annual population increase of 2%  and a cost of capital of 8% (long term bond yield) and you value the average Indian life at 52 lakhs.

People thought that the amount the AP government disbursed itself was on the higher side, yet we have come up with a higher number. The question is if our calculation is accurate.

We came up with the Rs. 1 lakh per head figure by taking the arithmetic mean of the productivity of all Indians. The question is if that is the right estimate.

Now, it is a well established fact that income and wealth follow a power law distribution. In fact, Vilfredo Pareto came up with his “Pareto distribution” (the “80-20 rule” as some people term it) precisely to describe the distribution of wealth. In other words, some people earn (let’s stick to income here) amounts that are several orders of magnitude higher than what the average earns.

A couple of years someone did an analysis (I don’t know where they got the data) and concluded that a household earning Rs. 12 lakh a year is in the “top 1%” of the Indian population by income. Yet, if you talk to a family earning Rs. 12 lakh per year, they will most definitely describe themselves as “middle class”.

The reason for this description is that though these people earn a fair amount, among people who earn more than them there are people who earn a lot more.

Coming back, if income follows a power law distribution, are we still correct in using the mean income to calculate the value of a life? It depends on how we frame the question. If we ask “what is the average value of an Indian life” we need to use mean. If we ask “what is the value of an average Indian life” we use median.

And for the purpose of awarding compensation after a tragedy, the compensation amount should be based on the value of the average Indian life. Since incomes follow a Power Law distribution, so does the value of lives, and it is not hard to see that average of a power law can be skewed by numbers in one extreme.

For that reason, a more “true” average is one that is more representative of the population, and there is no better metric for this than the median (other alternatives are “mean after knocking off top X%” types, and they are arbitrary). In other words, compensation needs to be paid based on the “value of the average life”.

The problem with median income is that it is tricky to calculate, unlike the mean which is straightforward. No good estimates of the median exist, for we need to rely on surveys for this. Yet, if we look around with a cursory google search, the numbers that are thrown up are in the Rs. 30000 to Rs. 50000 range (and these are numbers from different time periods in the past). Bringing forward older numbers, we can assume that the median per capita income is about Rs. 50000, or half the mean per capita income.

Considering that the average Indian earns Rs. 50000 per year, how do we value his life? There are various ways to do this. The first is to do a discounted cash flow of all future earnings. Assuming nominal GDP growth of about 12% per year, population growth 2% per year and long-term bond yield of 8%, and that the average Indian has another 37 years to live (66 – 29), we value the life at Rs. 26 lakh.

The other way to value the life is based on “comparables”. The Nifty (India’s premier stock index) has a Price to Earnings ratio of about 24. We could apply that on the Indian life, and that values the average life at Rs. 12 lakh.

Then, there are insurance guidelines. It is normally assumed that one should insure oneself up to about 7 times one’s annual income. And that means we should insure the average Indian at Rs. 3.5 lakh (the Pradhan Mantri Suraksha Bima Yojana provides insurance of Rs. 2 lakhs).

When I did a course on valuations a decade ago, the first thing the professor taught us was that “valuation is always wrong”. Based on the numbers above, you can decide for yourself if the Rs. 10 lakh amount offered by the AP government is appropriate.

 

Startup bragging and exaggeration rights

It seems to be common knowledge that startups like to exaggerate their results when they talk to the media. While I’ve known this for a long time, I was rather startled to see the numbers put out by a company I know, which seems to be an order of magnitude larger than what is actually the case. And when I was discussing with someone else in the know, I was told that this degree of overstating (especially to the media) is a common thing in the startup world.

In “normal” companies, overstatement of numbers is a massive crime, and shareholders can prosecute the management for such activities. Yet, it seems like investors in startups (funded startups seem to do this all the time) don’t seem to mind this at all. What is the difference?

“Normal” steady-state companies usually don’t have to raise capital too often. After they’ve raised a certain amount, hit steady state and gone public, raising more capital is a rare event. Also that they are public means that you have “gullible households” who own equity, and investor protection laws mean that they need to state incomes and other financial information to the best of their knowledge, and any cooking of the books can lead to prosecution.

For a startup, on the other hand, raising capital is a “normal” (as opposed to “extraordinary”) event, and its investors are mostly sophisticated investors (apart from gullible employees who have been forced to take equity for “skin in the game”). By overstating its numbers, especially in the popular media (hopefully now with the Registrar of Companies), startups can hope to create greater buzz which increases the likelihood of getting a next round of investment at a higher valuation.

Notice that in this case investors are also okay with the books having been cooked since they aren’t playing the dividend game but have a short term goal of raising more funds at higher valuations. And if overstating numbers can help that, so be it!