Forbes India 15th Anniversary Special

Have VCs been fair in valuing startups?

Valuation is not directly proportional to profits. Those in the business of investing know the art and science of valuations, Vikram Gupta, the founder and managing partner, IvyCap Ventures, writes

Published: Nov 17, 2022 02:17:09 PM IST
Updated: Nov 17, 2022 02:53:22 PM IST

Have VCs been fair in valuing startups? Today, nearly 95 percent of these startups may be loss-making and significantly burning cash. Yet, many of them raised funds and some even raised money in IPOs. Illustraton: Chaitanya Dinesh Surpur

 In India, over the last 10 years, we have seen substantial growth of startups as well as capital chasing them. Thanks to the efforts of the government to boost the startup community, the number grew by 8,971 percent: From 726 in FY17 to 65,861 in FY22 (as of March 14). India is the third-largest startup ecosystem in the world. But the bigger question is ‘When will loss-making startups turn profitable?’ The answer lies in the execution ability of founders and the business models they run. Today, nearly 95 percent of these startups may be loss-making and significantly burning cash. Yet, many of them raised funds and some even raised money in IPOs.

Earlier, the Securities and Exchange Board of India (Sebi) didn’t allow loss-making companies to go public. As a result, several of them opted for ways outside the country to go public. However, the government did not want these startups with future potential to move out of India, and enabled unprofitable companies to raise funds, limiting them to only 10 percent of share capital.

That raises the questions: Why would investors invest in loss-making startups?
Not many people understand how valuations are derived in startups. A professor will tell you that valuation is a function of future free cash flows. The theoretical valuation of any startup is an estimate of the profits it can generate over its life. In the early stages, there are too many variables that can lead to a very wide range of assumptions on how the future would look for any business.

Most startups may go through multiple pivots before settling on a business model that works for them. This makes it even harder to project their future cash flows. Amazon was launched in 1994 as a book store. And it IPOed in 1997 on a business model that looked completely different at that time. However, if your bread-and-butter depends on the business of investing, you will have to learn the art and science of valuations.

The assumptions for valuing a company include a few important aspects: (1) The macro factors and industry view that include size and growth of the industry. (2) Competitive pressures on pricing and growth of the business. (3) Capital efficiencies achieved due to scale of the business.

Some factors that may go beyond the academic exercise of valuing a company include: (1) The confidence in the ability of entrepreneurs to execute a business plan. (2) The demand and supply of the capital available at the time of negotiating valuation. (3) Company’s existing cash flow situation. (4) Exit objectives of the investor in terms of timelines and target IRRs (internal rate of return).

Also read: How the startup capital and valuation game has changed in India

The last few months have been challenging for the financial markets. The public markets and technology stocks have corrected significantly, and continued tightening is expected by central banks across the world. There is concern about a tech meltdown and the viability of unicorn business models. As a result, the valuations of many startups are under stress and many companies have announced retrenchments. However, I believe there is a strong bottom-up innovation and technology funnel in India.
While the correction reflects questions on sky-high valuation constraints and questionable business models, there is little doubt that technology and innovation will continue to be long-term trends. For discerning investors, it presents an opportunity to pick up winners that have sound businesses at more realistic valuations; sometimes higher valuation shouldn’t hurt as much. There is a lot of dry powder with investors for the asset class to continue to fund the innovation of strong companies with sustainable business models, which we believe will continue to drive the growth of this sector. This asset class, by definition, is a long-term investment and, therefore, less vulnerable to short- to medium-term shocks of the public market.

Venture capital (VC) in India is one of the few asset classes that gives investors exposure to privately-held emerging companies that promise to deliver high compounding returns in a high-growth environment over the long term with substantial multiples. True, profits and profitability are the discerning factors for any investor, but there are other reasons that can serve as determining factors.

For any investor, a customer base is one of the fundamental criteria for investing in a startup. Another factor is whether the company will be able to return the marketing cost.

The valuation of any company is not directly proportional to its profits. As investors, we look beneath and beyond mere numbers. For us, it is the value they bring to the entire ecosystem, the customers and the stakeholders they are associated with. While there can be several startups in a similar space, what sets one apart from the others is their business management efficiency and competitive advantage. These make the valuations of the startups higher, even if they are incurring losses.

Also read:   Niren Shah, Norwest India, and the art of slow and meaningful VC investing

Our successful approach at IvyCap Ventures has focussed on good businesses, differentiated companies with excellent founders and capital-efficient mindset. We have also had our share of investing in loss-making companies.

It is the vision of the investors and their comprehension of the brand value that help them understand the future growth trajectory of a startup despite their incurring losses. It is this brand value and the earned market goodwill that the investors bet their money on, which makes the valuation of a company much higher. In addition, there are times when the prospect of a lucrative alliance makes the startup a valuable one.  

Thus, it is the accumulation of several factors, not merely the profit numbers, that raise the valuation mark of any startup. And I believe it is justified as long as they can showcase the value over valuation in the long term.  

(Gupta is founder and managing partner, IvyCap Ventures)

(This story appears in the 18 November, 2022 issue of Forbes India. To visit our Archives, click here.)