Startup Funding and Valuation Bubble, Is It the Beginning or the End?

Startup Funding and Valuation Bubble, Is it the beginning or the end?

                                                                        Saswat Satpathy

                                                                                        8895595341

                                                                                                            um16350@stu.xub.edu.in

“Sweat Equity is the best Startup capital”, words spoken by American Businessman and Investor Mark Cuban, popular among the general populace as the owner of the NBA’s Dallas Mavericks and as a shark investor in the popular TV reality show “Shark Tank”. In a perfect world, sweat equity would have equalled capital inflow into a startup, but that equation is best left for philosophers to argue and ponder over. In today’s world, startup funding is a whole different ball game and making sure that you find an investor to put his/her money in your idea can be quite tricky to say the least. But over the period of years, after the breakthrough success of startups like Twitter, Amazon, Airbnb, Dropbox, etc investors started looking for the “next big thing” and thus started a phase where people were willing to throw exorbitant amount of money at startups, so as not to miss out on the chance to be a part of the next Facebook.

What this has led to is over valuation of these businesses, but, the market is rapidly correcting itself. For instance, when Square, the San Francisco payments processor, said it expected Wall Street to value the company at up to 4.2 billion dollars, considerably less than its original estimate of 6 billion dollars but when the IPO finally came out, the stocks were priced at a humbling 8.75$, well below its earlier forecasted range, pushing the company’s valuation still lower. A simple explanation for this is the transparency that is beginning to set in the market about these so called “Unicorns”, i.e. startups that are worth 1billion dollars or more. In reality these valuations are implied valuations, which are obtained when smaller stakes are actually traded in private markets. Also, the kinds of shares that are issued in these transactions are very different and have different provisions. Such provisions are either based on liquidation preferences or ratchets, where the former is basically a guarantee provided to the investors who are already concerned with high valuation levels and protects them from losing any money. Ratchets give an option to the investor of acquiring more number of shares, if the future valuations are below the price they paid.

The task of assigning a valuation for a startup which has little or no revenue and a less than certain future would seem like a guessing game for the uninitiated but there are metrics and methodologies that are in place to achieve this task, whether they are actually followed or not is a different story. The method that is generally applied while valuating a start up is the DCF (Discounted cash flow) method, which is an absolute valuation method as it is based on actual data. It estimates future cash flows and then discounts them to arrive at a present value. If this present value is more than the current cost of investment then the opportunity is considered good. Since many Venture capitalists (VC’s) have exit on top of their minds, they follow the Venture Capital Method which is based on expected rate of return at exit. Similarly, there are multiple such techniques at the disposal of VC’s, angel investors and other financial institutions but it all comes down to the financial foresight, better known as “a hunch” on the part of the investors when the time comes to take a final call.

It is safe to say that startups live in a hyper-cyclical world which is continuously driven by mutually fortifying dynamics of burn (money being spent) and valuation. The question that always remains is whether the burn is generating enough revenues, which in turn justifies the valuations. Absolute valuation is the wrong benchmark to focus on as it is an output which is prone to overshooting, with the last couple of years being a perfect example. Companies associated with high growth attract higher valuations which help them to raise capital. This capital generates further growth which raises the valuation again and the cycle continues, each time with a much stronger and forceful positive feedback loop, putting pressure on the companies to keep delivering on higher growth even when their avenues of creating the same are finite. This leads to companies opting for investments at the cost of profits.