Funding and Startup Valuation Bubble

‘Funding’ and ‘startup valuation’ are buzz-words these days. With funding of millions of dollars, valuations of many newborn companies have crossed the mark of  one billion dollars. Amazon is pumping $3 billion in Amazon India, Alibaba is investing in Paytm and many more startups are getting funded.

A comparison of the valuation of these startups with decade old companies can be very interesting. Flipkart founded in 2007 had a valuation of $15 billion (Rs 100,000 crore) in May 2015. In comparison, the stock market values of Tata Motors founded in 1945 was at Rs 95,000 crore. Hindalco, India’s largest aluminium company has a market valuation of Rs 16,000 crore. Snapdeal, which began trading just six years ago, is valued at Rs 35,000 crore. India’s biggest airline, Jet Airways, with large assets, is valued at Rs 3,800 crore. In stark contrast, asset-light Ola Cabs, the app-based taxi-hailing start-up, is worth Rs 30,000 crore.

Recently Morgan Stanley has marked down start-ups in the US such as Palantir and Dropbox as global investors turn cautious on new ventures with high valuations and no clear path to profitability. The total value of Flipkart has touched a low of $9.4 billion. Fund-raising has also become more challenging for start-ups, both in India and the internationally.

Why and when startups need funding?

Startups need funding to grow faster and avoid valley of death. “Valley of death” is a term referring to the time from when a startup firm receives an initial capital contribution to when it begins generating revenues. During the Death Valley curve, additional financing is usually scarce, leaving the firm vulnerable to cash flow requirements.

StartupFinancingCycle_reg_4.jpg

The early stage investment is called as Angel funding whereas venture capitalists enter a little later. VCs or funding partners aim for potential exit through M&A or probability of the company getting listed as a public limited company. But for an ‘exit’ to happen, someone else has to ‘enter’.

How is valuation calculated?

Companies are valued based on the expectation of future profits. Valuation is mostly about perception and how good a sales pitch the CEO can make. Some of the key factors considered while calculating valuation is-

  1. The potential of the idea/product What is the solution that company is providing? Is it really going to be the next big thing? The ‘hotness’ of the industry attracts more investors. E-commerce, mobile wallets, payment banks, driverless cars – these ‘disruptive’ technologies will transform the way we work, consume, travel and pay. It is this transformation that VCs and PEs are betting on.
  2. Traction What is the existing user base? How fast can a company convince more users? The deals of LinkedIn and Whatsapp were valued at $ 26.2 billion and $19 billion respectively because of their strong user base across the world.
  3. Reputation (founding team) The kind of reputation Elon Musk or Jeff Bezos bring to the table warrant more valuation. A successful startup often has more to do with the founders’ ability to execute rather than starting with a truly brilliant idea. The background of the founders, their previous projects and their exits, influence valuation.
  4. RevenuesRevenues are more important for the B-to-B startups than consumer startups. Valuations always include a bit of mystery, but those more mathematically inclined will appreciate adding revenues to the equation.

Issues with funding and valuation bubble

Most e-commerce sites like Flipkart and Snapdeal focus on gross merchandise value (GMV) to pitch their stories. GMV is misleading for three reasons- First; it reflects the total value of goods and services transacted through the site, not the actual revenue earned by it. The real revenue of e-commerce sites is broadly around five per cent of their GMV. Second, the huge discounts offered are not excluded from GMV. Third, companies can temporarily boost GMV by offering huge discounts on trending products like mobile phones. Such kind of sales are not sustainable but they help in the immediate round of funding and valuation.

No start-up is listed; so scrutiny by financial analysts is limited. Their balance sheets, though, are available on the Registrar of Companies (RoC) website and it’s clear that actual annual revenues are in fractions of the GMVs.

Questions are now being raised: is the hype overcooked? The US offers a glimpse of the future for e-commerce start-ups. Amazon, only recently, announced a quarterly profit after 21 years of being in business but commands a market value of $260 billion, which is more than that of America’s largest retail chain Wal-Mart (market value: $230 billion).

There is no fixed plan to grow and higher importance to time over money. One fine day, they want to target one whole country as a potential market. The next month, they are scaling down operations after burning millions trying to scale up. There will be plans to go ‘app only’ and then there will be a sharp U- turn. (Example: E-Commerce and food delivery startups).

The money spent on customer acquisition is absurd, which is obviously not turning into profits. The willingness to capture more and more market share is dangerous. When the users talk about the cash backs and discounts associated with a product instead of its utility or experience of using it, there is something seriously wrong with the business strategy of the company. Most of the tech startups are acquiring customers by offering discounts, which is justified, given the huge technology-adoption potential in India. However, if a company has to pay users to keep using the product, it is a serious misappropriation of funds.

After some years, three-four resource-rich and efficient players will remain in these business areas. Most of the small players will either experience a painful death or get acquired by big companies if they are lucky. Thus an openly competitive market gets reduced to an oligarchy.

The startup ecosystem, thus will shift to course-correction. We have started seeing this in the case of food delivery and grocery startups. There is an interesting dialogue in the movie Interstellar which makes us ponder- “Will ever such time come when we will need food more than any fancy innovation?”.
And the answer is- yes, it will come when innovations create ‘Redundancies’.

When is a redundancy created? When you already have enough resources to get something done, and yet you get more resources that add no value, while totally missing out on what is essential to keep us going or progress. An insane number of food delivery startups remind me of the same dilemma.

Some other key concerns are wage distribution and volatility of jobs. Silicon Valley employees are commanding ever increasing wages, with reports of $500,000 annual pay packages offered to recent college graduates. Interns are making $7,000 or more a month. Expectations for such sky-high pay have become both inevitable and unsustainable; they’re reminiscent of the $1 million pay packages promised to Wall Street associates in 1999. By 2000, once the party had ended, annual bonuses were being replaced by pink slips!

In the book ‘HR scorecard’,  the authors talk about a very important phenomenon- “Organization has to be a compelling place to work to make the company a compelling place to shop”. This can’t be achieved just by offering attractive pay packages but by having a right strategy.

In a recent article in The New York Times, Katie Benner sounded a warning from the Silicon Valley: “Start-ups that cannot adapt to a world that prizes profit over growth may ultimately be forced to raise money at the same or lower valuation than in the past, something referred to as a ‘down round’. Those can be debilitating: employee stock options usually become less valuable when a firm’s valuation falls, making it harder to retain people”. The concern about valuation bubble is exactly the same in India too, “Of recent, the valuation game has turned into a ‘black magic art’ more than a science,” Ravi Gururaj, the then chairman of India’s National Association of Software and Services Companies (NASSCOM) product council, told Quartz in March 2015.

The way forward

As Warren Buffett put it, “It’s only when the tide goes out that you can see who’s been swimming naked.” Recent reluctance to go public and valuation markdowns suggest we’ve reached high tide — and we’re about to discover who’s most exposed.

So the question arises, will these ‘fancy’ startups (Ola, Flipkart, Paytm, etc) not get funded anymore? The answer is – they will. It’s just that their growth and valuation will go down because we need e-commerce and internet technology startups. The valuation bubble is a global one.

Imagine the Dotcom Burst. The money is there, those who deserve shall get it. According to the research, 92% of the startups fail in first 3 years, but if startups pivot successfully at the right time they might survive and come across a good business model. Wal-Mart takes parking fees, promotional advertising fees. They’ll even service the car we drive there. Does that mean they have failed at selling grocery?

If entrepreneurs ask few questions using approach of 6 thinking hats, it will give them more clarity and stop from falling in trap of startup bubble-

White Hat -What solution will the business provide?

-What are the required and available resources?

-Is this the good time to raise funds? Who will give funding?

-What valuation do we want? How can we make this model profitable?

-Why did startups fail in spite of funding and how to avoid those traps?

-How much equity to dilute for funding?

Red Hat -Hesitation?  Fear of losing? Excitement? Concern?
Black Hat -What are the weak points of the business plan?

-What could go wrong? What is my plan B?

-What will happen if the required funding is not raised?

-What will I learn if something goes wrong?

-What if the startup fails?

Yellow Hat -What are the benefits of this decision?

-How to create a successful business using this decision?

-Where should we make the investment after getting funding?

-What is the plan of action once the financial problem is solved?

-When will the firm achieve breakeven point?

Green Hat -What are the other ways to raise funds?

-Why not operate as a lean startup?

-What are the solutions to arrest probable issues?

-Is expansion at the cost of equity is necessary?

Blue Hat -How and when profitability can be achieved to avoid external support to business?

-How do other employees and stakeholders look at this decision?

Conclusion

Getting a higher valuation in the first round isn’t a victory, maintaining that valuation in future matters the most. There is a huge difference between the valuation of billions of dollars and liquidity. The problem is that start-ups are surviving on VC/PE/angel money, and not on earned profits. When that source eventually dries up, some will go belly-up. Companies with no real business models will die anyway. Startups are also often pressurised by VCs and Private Equity people to scale too fast. In that race to chase growth, a lot is sacrificed.

Entrepreneurs need to focus on creating more value and profit rather than on raising more and more money to boost valuation. Upon going for an IPO, company’s listed price shall not match the company’s valuation at the last round of funding. This is going to cause a major crash where early exits will be lauded & a lot of investors are going to be an unhappy lot. Only those with business models that generate real cash profits will survive and a few thrive.

(Sources- Business Standard, Economic Times, Entrepreneur, Forbes, Yourstory, Wall Street Journal, Inc, Business Insider, Pbs)

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About Mukesh Bhavsar

Mukesh has done BE Civil from Mumbai University and MA Political Science from IGNOU. He is currently pursuing masters in HR Management from Tata Institute of Social Sciences (TISS). He has worked for a couple of NGOs in India and UK. He has also written for some newspapers and magazines on different social issues. He was one of the 20 volunteers of India-UK Global Xchange program in 2011. Mukesh is interested in entrepreneurship, writing, social work, travelling, and photography. Follow him on twitter- https://twitter.com/mukeshbhavsar88
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