Why do Startups with Highest Valuations makes the Least Profits.

Startup Valuation: Understanding the Intricacies

What is Startup Valuation?

In simple terms, startup valuation is the process of determining a firm’s value. During the seed fundraising round, an individual investor trades capital for a portion of the company’s stock. This valuation is crucial for entrepreneurs, as it helps them determine how much ownership they must provide to a seed investor in return for financing. It’s equally important for investors, who need to understand how much of the company’s stock they will receive for their investment. Startup valuation can be a deal-maker or a deal-breaker and does not include speculation based on the valuation of other comparable businesses.

Why Do High-Valued Startups Often Have the Least Profit?

Startups often prioritise their long-term vision over immediate profits. Instead of focusing on current profitability, they emphasise their potential for future profit generation. Founders use innovative techniques, technologies, and solutions to attract investors, coupled with compelling storytelling and effective selling strategies.

Investors are often inspired by the founders’ exclusive pitches and invest in startups, hoping for future profits. Both parties work based on future assumptions, betting on the startup’s ability to outcompete rivals and create a market niche. However, when things don’t go as planned, high-valued startups can struggle with profitability.

The brand name and its perceived worth often attract investors, driving up valuations. For instance, Groww, an investing platform, raised its valuation to $3 billion in October 2021 despite minimal profits. In contrast, Zerodha, a highly profitable financial services company, has a lower valuation than Groww.

The Role of Discounted Cash Flow in Valuation

The discounted cash flow (DCF) method is used to value startups. It forecasts future cash flows and the anticipated return on investment. Startups destined to struggle with income generation are assigned a higher discount rate.

Such startups may continue to secure high valuations through additional funding rounds. However, once investors analyse the data and realise these startups may not succeed, they often withdraw further funding. This can lead to business closures or downsizing, potentially causing job losses and economic repercussions reminiscent of the 2008 financial crisis.

As Kunal Shah, CEO of CRED, states, “Unicorn tag, high valuation are all vanity metrics till the company delivers profits.”

Cases of High Valuation, Low-Profit Startups

Zomato

Zomato’s revenue has significantly increased year over year, but so have its losses. Despite this, Zomato’s presence in 24 countries and its monopoly in the Indian restaurant search market suggest a strong likelihood of future success. In FY22, Zomato recorded a revenue of $505.76 million, with a loss of $145.92 million. Its brand value continues to attract funding.

Ola/Uber

Before Ola and Uber, getting a bus or taxi involved numerous refusals. Now, we can book a cab from the comfort of our homes or offices. This convenience, along with cashless and air-conditioned rides, has built strong customer trust and habits. In FY21, Ola Cabs recorded a revenue of $125.41 million and a loss of $101.27 million. Despite their losses, these companies maintain high valuations due to investor and consumer trust.

Conclusion

High valuations often reflect investor confidence in a startup’s long-term vision rather than its current profitability. While this can lead to impressive funding rounds, the true test of a startup’s success lies in its ability to eventually deliver profits.