The Race for Astronomical Startup Valuations – Can the Trend Hold?

Numerous billion-dollar startups – or Unicorns – have assumed significant roles, offering solutions and services that are deeply entrenched in our lives. According to CB Insights, India had 29 of the 642 unicorns worldwide in April 2021, a number which has scaled up to 79 by Mar 2022, with 42 unicorns getting added in 2021. India is expected to have 100+ new unicorns by the end of the year. Startup valuations above $1bn is no longer a rare phenomenon in India.

However, this begs a logical question – ‘How do these startups command astronomical valuations without clocking revenues or profits?’ In today’s world, a startup’s worth is primarily measured by its valuation rather than the scale of operations or quality of its products and services. Startup founders always have high (read ‘unrealistic’) valuation expectations for their businesses while the understanding about how value is truly derived remains somewhat obfuscated. Contrarily, pre-revenue investors ideally prefer lower valuations that assure a higher return on investment (ROI).

Typically, investors use different valuation techniques to estimate startups worth at a pre-revenue stage. Some of the common valuation methods that applied at a pre-revenue stage include:

• Berkus Method: Assesses startups basis five key aspects to calculate value – concept, prototype, quality management, connections (strategic relationship) and launch plan
• Scorecard Valuation Method: Valuation is based on factors (and assigns specific weights) such as management team, opportunity size, product, competition, sales/marketing and financial need
• Venture Capital (VC) Method: A 2-step process – 1. Calculate the terminal value (expected value of the startup on a specific date) of the business in the harvest year (exit by the investor); 2. Track backward with the expected ROI and investment amount to calculate the pre-money valuation

Some firms also use the Discounted Cash Flow (DCF) method to estimate startup valuations at a revenue generation stage, which entails using financial projections (typically five years) and then discounting it after certain adjustments. However, it might not be the most useful method at the pre-revenue stage, given all the assumptions and the relative inability to reliably estimate the projections for company at this stage.

The Indian startup ecosystem is strewn with examples which expound the pitfalls of such valuation approaches. For instance, multiple experts claim that valuations for Zomato, Practo, Paytm and Oyo are extremely high. Although other factors like growth rate, age, sectoral maturity, and leadership will play a role, these startups will have to double their base metrics every year for the next 3-6 years to finally justify their valuations and be in-line with their peers. These exorbitant valuations also lead to undue pressure on companies to deliver on performance, which falters at times.

• ShopClues, which became a Unicorn in 2016, had to shut down operations in 2019. FY18 financials of ShopClues reported a 50% revenue growth and a 40% dip in losses – a positive sign. However, an in-depth analysis reflected piling losses for years, especially as the funding rounds were unable to keep up with the burn-rate
• Unacademy – another unicorn – laid off around 1,000 employees recently, at the time when it sponsored the IPL in a three-year deal (valued at $1m Cr), questioning company’s fundamental principles
• Further, Byju’s, Indian cricket Team sponsor, was unable to completely raise $800m through fresh equity rounds – raised $400m from investors and had to raise $400m term loan (debt) from international banks (against 2% stake as collateral) – indicating lack of investor confidence on pumping in more money in the business

Such instances firmly establish the fact that the trending methods and practices of assigning enormous valuations and unicorn tags to startups, unless financially justifiable, are fruitless and even detrimental to the startup ecosystem. There is rerating and downrating happening across multiple new and matured startups as the growth story painted by them earlier is no longer reflecting on ground.

On the contrary, there are multiple examples of bootstrapped companies that have done wonders – EaseMyTrip, set out an example in the industry by becoming a unicorn in Sep 2021. It significantly reduced marketing and promotional expenses to become profitable. Zerodha is another unicorn, which posted a profit of $240Mn on a revenue of $560Mn in FY 2022 without any external funding.

Further, ample voices of concern are erupting that are questioning the mad rush for valuations alone, when operating fundamentals remain disregarded. And this, then, leads to another logical question – ‘Is this proliferating approach towards bizarre startup valuations worth the long-term risk?’ New-age entrepreneurs should not completely rely on investors’ money to grow their customer base. Instead, they should strongly focus on business fundamentals of revenue and margins for sustained and consistent valuation.

Author: Manish Mishra,

Head, Strategy Consulting