At some point in 2017, the shared-office company, WeWork, received a valuation equivalent of $550,000 per customer. Fast forward to 2019, WeWork went from being Wall Street’s startup darling to a startup disaster. After raising billions of dollars from private investors and riding on SoftBank’s whopping $47 billion valuation, WeWork readied an IPO (Initial Public Offering) — only to have it withdrawn. The botched IPO and the fall from grace of WeWork served as a wake-up call to entrepreneurs, the tech sector and the investor community at large to be wary of bloated valuations. Similarly, the failed IPOs of Uber and Lyft have made investors approach hi-profile and ‘hyped’ startup valuations with increased caution.
Not just the global markets, in India, too, the burgeoning rise of startups has turned the spotlight on homegrown tech unicorns that have transformed the entrepreneurial landscape in the country. While unicorns have contributed to India’s global startup hub status, the phenomenon has also led to a fallacy — that all startups can become billion-dollar companies. It is far from the truth.
The combined valuation of unicorns in India grew to $71 billion in 2018, a jump from $38 billion in 2017. However, the recent debacles of overvalued startups could serve as a warning for startup founders to help them differentiate between ridiculously overvalued numbers and the actual value of their company that requires careful assessment.
Be pragmatic about the valuation of your company
Investors are looking for startups that have the potential to become significant businesses. And the fastest way startup founders can scare away potential investors is by pegging their company at an unrealistic number. As any episode of ‘Shark Tank’ shows, while it is easy for entrepreneurs to get carried away by their company’s projected valuation, they need to justify to investors how they will get to, say, $300 million in three years.
On the flip side, it is a challenge for investors to value pre-revenue companies. Investors carefully consider factors beyond monetary terms, such as customer-engagement model, market size competition, the quality of the founding team and other dynamic market forces before calculating the value of a startup. As is commonly acknowledged by ecosystem stakeholders, valuation is a combination of art and science and are guesstimates that early-stage investors try to assess before making their choices.
Understand the valuation jargon
Though valuations are largely based on subjective assumptions, founders have to rely on industry best practices to estimate valuation and pitch before investors.
There are any number of ways of arriving at the valuation of a new company. The Direct Valuation method and Indirect Valuation method are the two main ways in which valuation is done. Berkus, Book Value, First Chicago, Venture Capital and Discounted Cash Flow are some of the other popular valuation methods to determine pre-money valuation. Discounted Cash Flow is a direct valuation method that can be applied to startups as it enables investors to estimate the expected cash flows before deciding to invest in the startup. The venture capital method is perfect for investors looking for an exit in the short-to-medium-term. Towards this end, the investors estimate the exit price and then the current post-money valuation, accounting for time and various risk factors.
Undervaluation could be detrimental to your startup’s health
While entrepreneurs should not overvalue their companies, they should also steer clear of undervaluing them. Investors will reap immense benefits if founders give away more equity to them. It could pose a problem for future investors as the value of the company would have been diluted by the founders, resulting in the loss of control over major decisions. The percentage of the equity to be given away is a decision that should be taken much ahead of the company becoming a valued entity. Thus, the foresight and vision of startup founders is key to determining the company’s future value in the market.
A well-executed exit strategy adds to the company’s value
For a startup founder, there will invariably come a time when an exit strategy has to be planned. The value of a business also depends on how well the exit strategy is executed. Investors are attracted to cashflow-rich companies that generate revenues and, thus, form their valuations based on comparable deals in that specific industry. Exit assumptions will take into consideration 5–8 years ahead of the anticipated exit or equity sale. Among other factors, an investor’s valuation metrics for a startup will be based on the company’s growth and its fiscals. Investors can create significant value for the startup while preparing for the exit as this will also ensure a smooth transition.
All things considered, irrationality may be the wild card that will earn your place in the unicorn club
Sometimes, unicorns get lucky even when their profitability takes a hit. For example, although Paytm parent One97 Communications Ltd. registered a consolidated loss of ₹4,217.20 crores in FY 2018–19, investors remained bullish about the company and valued it at $15 billion. Likewise, Walmart didn’t dither over its acquisition of Flipkart even though the latter posted losses of ₹2,064.80 crores in FY 2018–19.
Valuations are generally based on future earnings. However, in the current investment climate in India, leading global investors such as SoftBank are literally putting their monies on unicorns that are touted to be here for the long haul — despite their incurring massive losses and burning cash to meet their meteoric growth. As trends continue, only time will tell whether it’s time for a wrap of the tech IPO market — a hark back to the dot-com bubble era that went bust.
