Realistically inflated valuations of startups

REALISTICALLY INFLATED VALUATIONS OF STARTUPS

In recent times startup’s success has become synonymous with valuation. With the surge during and after the pandemic, startups garnered everyone’s attention, but startups have their eye on valuation!

India witnessed 25% unicorns out of the total unicorns in E-commerce & Direct to Customer, followed by FinTech at 23% [source: CB Insights Global Unicorn List (as of 6 April 2022)].

How is this working for valuation?

Valuation is almost always alleged to be inflated as the near-term projected returns are based on the potential of the idea being sold by the startup and not actual estimated profits. The valuation is assessed on qualitative data in the early stages of the startup. A concept rich in market scope and with acceptance by the public, higher valuation in the initial funding rounds. More on legal requirements, along with the funding options for startups, here.

Some questions which may help with assessment include:

  1. What is the industry growth rate?
  2. What is the survival rate of startups in the region?
  3. Can the business be scaled in the near future, or is it a long-term goal?
  4. Is it a product/service for a niche market?

These questions help assess the ambition and potential to arrive at a projected valuation.

REASONS FOR INFLATED VALUATION

Lack of specific laws in force, the projected returns are determined basis of how good the product/service is assumed by the founders. These projections for a valuation could get re-assessed owing to the good practices followed by the finance professionals.

There also is an element of lack of transparency in the valuation process. The investors rarely have an insight into the vision of the founders and could miss relevant information about the valuation ideology.

In the case of IPOs, the Companies Act and SEBI regulations protect retail investors requiring the prospectus to detail necessary assumptions which form the basis of the projected valuation. This is not a legal condition for angel investors or incubators, which makes the valuation process very discretionary at the hands of the founders.

A pitch deck is prepared by the founders where the relevant information is shared to seek funding. At this point, the temptation to rely on projected figures can be high for the founders.

Higher valuations result in easier access to funding sources, but this eventually can impede a profitable exit. Examples of these are the sharp decline in the current stock value for Paytm, Zomato, and Nykaa after being listed in IPO.    

RE-ASSESSMENT OF THE PROCESS

For an uninfluenced process, the valuers have to identify the real business value being delivered. This can be initially assessed with the evaluation of market acceptance and brand loyalty. Eventually, it may be re-adjusted YoY to keep the projected valuation for the next 5 years in check.

Experts also suggest using EBITDA as a measure instead of the scale of operations since sales has been challenging in the current market conditions.

Methods like Discounted Cash Flow, Cost-To-Duplicate, and Market Multiple can be implemented to value a startup in its infancy.

  • Cost-to-Duplicate method helps assess the cost required to duplicate the startup from scratch, which is usually the value an investor is willing to pay.
  • Market Multiple is used to value the startup in comparison to the cost of acquisition of similar companies in the market.

NEGATIVE DOWNTURN OF INFLATED VALUATION

The Rupee-Dollar exchange rate influences return on investments as the substantial investors in a startup could be foreign investors, including investment firms – investing in US Dollars.

Furthermore, a market correction leads to a valuation re-assessment, and a startup could potentially witness a considerable labour turnover or layoffs due to cash management.

WHAT NEXT TO EXPECT?

A SEBI directive now seeks parameters, viz., the date of the latest valuation, cost of total investments, and valuation of the investment portfolio. Also, if the valuation is based on audited or unaudited data of an investee, along with details about additional valuations and deviations from the methodology adopted for valuing a startup must be reported.

These metrics will introduce transparency, with better leverage to hedge any risks and invest in ventures with close to an accurate valuation.

SEBI will keep an eye on the credibility of the valuation process, the methodology employed, and the practices adopted by different funds, as regulating startups is difficult on aspects of valuation. 

This is only for informational purposes. Nothing contained herein is, purports to be, or is intended as legal advice and you should seek legal advice before you act on any information or view expressed herein. Endeavoured to accurately reflect the subject matter of this alert, without any representation or warranty, express or implied, in any manner whatsoever in connection with the contents of this. This isn’t an attempt to solicit business in any manner.

Sources:

  1. https://tinyurl.com/yc6m7a22
  2. https://tinyurl.com/545xed72
  3. https://tinyurl.com/fzhajxkd
  4. https://tinyurl.com/2hkr52tu
  5. https://news.crunchbase.com/startups/startup-valuation-how-to/
  6. https://www.investopedia.com/articles/financial-theory/11/valuing-startup-ventures.asp

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