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Valuation Bubble of the Indian Startup Ecosystem
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Investors are overvaluing several companies across different sectors in the Indian startup ecosystem. With shaky metrics, venture capitalists are more bullish than ever. Such stretched valuations have caused some worry. Is there a reason behind the madness, or does the country have a startup valuation bubble?

Startups have been a considerable part of the Indian business jargon in the decade. The country has witnessed some of the exemplary entities rise from rags to riches of the previous decade and noticed some dwindling. However, in totality, the past decade was more about growth. 

According to a KPMG report (1), more startups are merging worldwide, and in India alone, the volume of startups has increased from 7k in 2008 to a massive 50,000 by the end of 2018. Moreover, most of these companies have categorized themselves as ‘tech’ startups irrespective of their core businesses which may involve a completely different service such as food delivery, hotel stay, etc.

These startups’ valuation has been rising unbelievably, with the country’s highest-valued startup, Paytm, valued at over 16 billion USD. If that seems high, then it is worth noting that the highest valued startup across the globe has a 75 billion USD valuation, ByteDance Ltd, the parent firm of the worldwide phenomena, TikTok (2). 

The Market Shift

In October 2020, a cohort of investors jostled to invest in a fintech startup. The company did not need the money. It hasn’t even started spending the 60 million USD it had secured six months prior. It didn’t burn cash. Moreover, the startup had no plans to clock funds at least for another year. The market already priced it at an abrupt 300 million USD.

However, the investors, including some most prominent names in the industries and first-time investors in India from the United States, continued to nudge. Even though reluctantly and even bemused, the company’s founder agreed to secure money but at a double valuation in six months. The investors accepted. 

According to Moneycontrol (3), startups set an aggressive valuation by any measure and wait for investors to take the plunge. And in almost every case, they did. In some cases, even multiple investors queued up to pour investments.

However, a lot has changed in a year. In 2020, most venture capitalists addressed caution after years of enthusiasm and drove loss-making startups to sky-high valuations in India and the US. After Uber’s moderate listing followed by WeWork’s spectacular implosion led most investors to evaluate large cheques more carefully (4). And all of this was before the coronavirus pandemic, offering uncertainty and slowing down a whole new meaning. 

The rise in internet users amid the pandemic, unprecedented surge, and a sudden bounce back from lockdown took dealmaking back to its heyday. The valuations are rich, with growth always being the priority despite the shaky metrics. 

Investors are no longer determining valuations by fundamentals such as share price to earning or forward revenue multiples. Instead, they decide it by an urgency to invest, demand and supply, the fear of missing out, and growth-driven excitement.

For instance, Indian fintech startups such as Cred, BharatPe, and KHatabook are collectively valued at 1.7 billion USD. They have zero revenue.  

There were expectations that the online learning platform, Unacademy would have a revenue of about 400 crore INR in the fiscal year 2021, as per a person close to the company. It was valued at 2 billion USD, almost 35 times forward revenue (5). Even BYJU’s, India’s most valued edtech startup, has a 12 billion USD valuation with about 700 million USD expected revenue (6). While the numbers are aggressive, they are still far lower, multiple of 16 to 17 times. 

 

Are Startups Overvalued? 

What hits us hard is the revenues of these startups being much less for such huge valuations. The EV/Revenue multiple indicates the value of a company for every dollar of income it makes and looks substantial. Moreover, even though most of these startups are running into losses, they still have such humongous figures. It might be the industry standard. 

Let’s take a look at the valuation, revenues, and profits of some of the popular global and local startups. 

Source: LinkedIn
Source: LinkedIn

Now let’s take a look at some traditional tech companies and their valuation. 

Source: LinkedIn
Source: LinkedIn

We can see that these legacy companies are valued at significantly lower EV/Revenue multiple even when they are considered the industry’s finest organizations. Hence, we can also deduce that, after enough comparisons, that these startups are indeed valued far more exorbitantly than the conventional business leaders. 

Why?

As investors in the segment advocates, these tech startups can disrupt the market via their innovation and highly scalable business models compared to the conventional business forms. 

While these facts are actual, we can only extend them to specific points. There is also another perspective to these valuations that we tend to overlook. That investing in startups is also a business!

Venture capital and private equity firms predominantly invest in the startup ecosystem. Fund managers and general partners manage these funds by pooling money from HNI and institutional investors, Limited Partners to make a fund, and then investing in startups. They aim to generate revenues and offer returns to the investors and charge a management fee and a share of the returns as previously decided in the terms. 

We can also think of it as a mutual fund for NHIs. It is just very risky and hence offers incredibly high returns.

They invest in a startup intending to exit in some years at a much higher valuation. They would sell their share to another investor and would earn the price gap. There are several exit options for these investors. It includes selling their stake to another investor in further funding rounds, selling their claims to a giant entity in case of an acquisition, cashing out in an IPO (7). 

In short, these investors operate on the idea of ‘The Greater Fool Theory.’ It means that during a bubble, one can make money through assets even if they are overvalued and then sell them at an even higher price since there will always be a greater fool willing to pay a higher amount (8). 

Such practice widens the gap between the intrinsic value and perceived value of an entity. The marketplace overenthusiasm is another plausible reason for high valuations. 

 

The Valuation of Startups

Startups are pretty challenging to value due to the lack of cash flows, physical assets, and customers, bringing in the scope for subjectivity in valuations. A company that can be worth 10 million USD can be worth 1 billion USD for another. It depends on the investors’ trust in the idea, management, industry’s prospect, and the business plan (9). 

For a calculation, most investors value startups via these or a combination of these popular methods. 

It includes a DCF, discounted cash flow method. One forecasts the company’s cash flow in the future, again highly subjective, and calculates the current cash flows worth through an expected return rate. 

The second is comparable. One values a company compared to other companies of similar nature via different key performance metrics such as EV/Revenue, EV/EBIT, earnings before interest and tax multiple, or EV/Any comparable key metric. 

For example, if an X company has a 100 USD valuation with a revenue of 10 USD, the EV/Revenue comes out to 10 USD (100 USD/10 USD = 10).

If a company Y, similar to company X, is earning a revenue of 5 USD, the EV or valuation would be (EV/Revenue multiple, 5 x 10 USD = 50) 50 USD. 

Such valuation approaches are pretty subjective. Hence, even a single investor can influence a company’s entire valuation. It means that if an investor finds a startup up-and-coming and offers to invest 100 million USD for a 10% stake, the valuation of the company comes out to be 1k million USD or 1 billion USD. Similarly, if a new investor or the same investor is willing to offer 200 million USD for a 10% share in the subsequent funding round, the valuation would increase to 2 billion USD (10). 

Let’s take a look at a real example. There are two companies with similar offerings, while one is better than the other in almost all aspects but valuation. We are talking about two startups that offer co-working spaces, WeWork and IWG (11). 

Experts suggest that the difference is that investors valued WeWork more considering its growth factor while ignoring conventional metrics. While WeWork jumped in revenue more than 100% every year, IWG’s surged by a modest 10 to 12%. The growth factor and investment from an expert investor Softbank, seemed like a winning formula to other investors, except it was not. 

Even though one can easily manipulate valuations with these methods, they are widely used to value a startup today. 

What Do Startups Do With the Fundings?

Startups use millions and billions of dollars of fundings to run their operations and manage their cash flows so that they can concentrate more on growth and expanding their business. 

Today, the consensus is to survive and grow, and businesses need to expand their customer base quickly. Surprisingly, the sector’s growth is associated with a surge in customers and revenues while overlooking traditional performance metrics such as profitability altogether (12). 

Hence, as a default approach for companies nowadays, they use a substantial amount of funding for new customer acquisition by burning their investments to provide predatory pricing and lucrative offers to customers. Their immediate focus is to gain new customers even though its cost would take the company into tremendous losses. 

In such a scenario, where companies are operating with a vision to monopolize the market and the winner taking it all at the end, profitability has taken a back seat. 

The advocates of such an approach believe that once a business has customers in place, they can cover up for significant losses with even more prominent revenues in the future. 

 

Are We in a Bubble?

The signs of it are typical. Pedigreed founders, extensive markets, top early-stage VCs backing, high growth, and the chances of the next outsized round, even at a unicorn status, the covered billion-dollar valuation are high. Such extensive dealing is happening for unproven businesses, with valuation doubling and tripling in no time. The question arises, are we in a bubble?

It is pretty hard to answer since historically, only after a bubble has burst that most people realize that they were in one. 

According to an anonymous partner at a leading VC firm (13), ‘it is tough to tell at a time since we are going through a digital transformation. For a long time, the market size of the country was a huge question. With UPI, Jio, and now the coronavirus pandemic, digital adoption has surged in a way even bullish investors did not expect a year ago. Hence, startups would be priced on future value. And if one is a smart entrepreneur, the price would be even higher than many would expect.’

Rich valuation multiplication has also spilled over from other suspects, from enterprise software firms to consumer internet companies. It is new. 

For example, last year, SoftBank invested in Mindtickle at a 500 million USD valuation on about 20 to 25 million USD expected revenue (14). Even SaaS, Software-as-a-Service firms like Zoom, Slack, Cloudflare, and Snowflake in the United States have gone public in the past few years with booming progress. 

Karan Sharma, the co-head of digital technology at Avendus (15), an investment banking firm, believes SaaS valuations are pretty rich following the public markets’ frenzy. And a dynamic for a demand-supply chain, where investors want to get into a few late-stage quality SaaS deals, both private and public demands are higher and further expanding on it. 

He further added that there had been a bullish growth in investing behind industries that came out strongly from the pandemic, and high interest is driven towards select market lenders. Over the past several months, there has been a significant improvement in the unit economics and profitability profile in the growth stage. 

Sharma also says that one can always assume some rationalization at such levels. However, considering the market liquidity level, it may not be significant. There may be some volatility. However, a notable correction is unlikely in the short term. 

 

The Resemblance with Dot-Com Bubble

It is a bubble that came with a spike in the US technology companies valuation because of the sudden rise in the investment in these companies by the public from everyone, taxi drivers to venture capitals, to billions. When it became apparent that these firms were not likely to profit, the bubble burst as investors tried to exit. 

The NASDAQ surged over four times from 1k to more than 5k points from 1995 to 200 and then fell by more than 75%, to about 1150 points in 2002 (16). 

It happened because of the market overconfidence, funds abundance, overlooking business fundamentals, sudden technological advancements, which gave businesses the hope of market disruptions with new technologies. 

There have been several similarities noticed between the situation then and now. 

Both now and then, startups competed for haste expansion. At that time, so-called tech companies were spending on marketing generously while struggling to find a way towards profitability. 

Companies were previously also bragging about their disruptive strengths and potential to change the world. However, their money started to dry up, and investors reduced these companies’ valuation to half. 

There was also a widespread euphoria washed down with the realization that thousands of people in once-promising businesses are prone to lose their jobs. 

 

The Present Scenario

The situation is comparatively better, considering that there has been negligible public involvement in investments and valuations. Additionally, IPOs, Initial Public Offerings have hinted at general sobriety instead of a mass mania. 

People are not relying on the valuation factor while purchasing companies. We can see the difference between the share prices of stocks of companies such as Uber, Peloton, and Lyft today and at their IPOs. Uber’s IPO was priced at 45 USD per share and is trading at about 60 USD. Peloton’s IPO was priced at 29 USD and is presently trading at 115 USD. Whereas Lyft’s IPO was priced at 72 USD, and today, it is trading at less than 64 USD. (as of April 7, 2021)

Even though the scenario is different, how far it is different is worth scratching the head. We need to comprehend that these startups receive fundings from large fundings, and their operation relies on these investments. Without these fundings, they may run into a cash crunch, which would affect their operations. A world tragedy, a recession, or even a mere investment loss can lead to a reduction or even an end of a company’s investment in the future. 

The question is whether these companies are disruptive and sustainable in the long term without the requirement for investors to pour millions into them? 

Last year, we witnessed how a long-term investor Softbank bailed out from WeWork. It shows that investors may not hang with a company forever, and there is always a chance for it to bust. 

We saw WeWork, which was valued at 47 billion USD to go to the bankruptcy talk within six weeks (17). 

The fall of even a handful of significant companies can rapidly change the market sentiments. It can also lead to a domino effect in the market that can lead to diminishing investments in the startup ecosystem and may also lead to recessionary scenarios in the worst case. 

 

What’s Ahead?

If you think that history chooses to repeat itself, and all startups would fade away, then hold your horses. Even if historical rules prevail again, even if the position starts to wear out, companies with solid fundamentals will pave its way for sustainability again. 

Even though organizations such as Google, Amazon, and eBay had suffered when the bubble burst, they were robust enough to sustain the situation and come out stronger and established themselves via shrewd accounting and effective business strategies, based on more tangible things than mere blind faith. 

Even to date, in the tech startup space, certain firms have solid fundamentals and can improve users’ lives and continue their existence. It is especially true for core-tech companies.

A prominent example is AWS, Amazon Web Service, which has contributed more than 50% of Amazon’s total profit even after having the most petite sales figures, 11% of total revenue compared to Amazon’s other business verticals (18). 

One of the reasons that several startups struggle to achieve a lift-off is because their feet are still stuck in the physical world’s mud. 

Nevertheless, some startups are more credible compared to others!

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Rucha Joshi is fueled by her passion for creative writing. She is eager to turn information into action. With her hunger for knowledge, she considers herself a forever student. She's currently working as a content writer and is always interested in a challenge.

Disclaimer: The views, thoughts, and opinions expressed in the article have been curated for our audience and does not warrant a 100% accuracy. All the information mentioned in the article is subject to change according to the changing viewpoints. Feel free to reach us at [email protected] for any change or copyright issues.

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Rucha Joshi
Rucha Joshi
Rucha Joshi is fueled by her passion for creative writing. She is eager to turn information into action. With her hunger for knowledge, she considers herself a forever student. She's currently working as a content writer and is always interested in a challenge.

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