In the past few years, India has become a lucrative space for startup investments and many reputed startups have also released their IPOs (Initial Public Offerings) and have thus hit the public market in doing so.
All these firms and IPOs were backed by investors from across the board. However, the stock pricing of these startups and their IPOs has been wild – thus raising questions about the credibility of their valuations during their pre-IPO funding rounds.
Let us first study the difference between the price and value of a startup –
The ‘price’ is what the market thinks a company is worth, while the ‘value’ is what an investor believes a company is worth based on its revenue and other numbers.
Now, you need to understand that each investor has a different parameter for assigning value to a startup. Here are some questions a typical investor asks themselves and the founder when gauging the valuation of a startup –
- Is the company a solution provider for a large customer base?
- Does the startup have a hockey stick shape growth trajectory?
- How long till the startup figures out its ‘how?’ and ‘when?’
- What’s the customer acquisition cost?
- How is the team performing?
- How flexible is the product to the changing trends and behaviour of the customers?
- What’s the appetite for risk, knowledge, and access to resources?
Nevertheless, apart from the abovementioned uniform questions, almost all investors value a startup based on one core belief – Eventually, all other investors (the market) will also come to the same assessment as mine, and the price will converge to my estimate of value.
Now let’s talk about the valuation methods prominently used –
Income-based approaches focus more on cash flow, scenario-based weighted valuation, and venture capital methods. In this method, investors develop a rough estimate of the future cash inflow and outflow. This is done for a future date when the company would have achieved the desired scale and valuation using fundamental metrics like profitability is possible.
Market-based approaches determine an asset’s value based on the selling price of similar assets. It is one of three popular valuation methods, along with the cost approach and discounted cash-flow analysis.
Hybrid methods involve scorecards using a combination of qualitative and quantitative parameters, each bearing a certain weight or value. Depending on the industry and the company’s stage of development, key parameters are identified and compared with competitors or other startups operating in the same broader industry.
But in the end, each startup is different –
And so is the risk-taking ability of every startup – depending on its products, revenue model etc. Most Venture Capitalists take a call on some 20 startups on average knowing very well that only 2-3 might perform well and hit it out of the park.
Mostly, it is also a question of what terms VCs demand the equity. VCs are entitled to special rights like liquidation preference, participation rights, etc., that offer protection to their capital in certain situations.
Valuing startups requires multi-disciplinary skills that intersect various dimensions — industry expertise, financial chops, technology perspective, and behavioural sciences.
Therefore, selecting the appropriate valuation methodology often demands a deep understanding of nature and revenue models in startup ecosystems.
Remember the bottom line: The story behind the number is equally important, if not more