Beneath the surface of our daily life, in the personal history of many of us, there runs a continuous controversy between an ego that affirms and an ego that denies it. On the course of this controversy depends the attainment of inner harmony and consistent conduct in private and public affairs. These words of Beatrice Webb-which I serendipitously chanced upon in a book on a London trip and stuck with me since then-perhaps best explain the conflict between the outer world and one’s inner world, now being seen almost daily in the fast-paced world of startups.
Increasingly, for every event in this space, there are two kinds of reactions that are seen, one, a validation which appeals to the affirming ego and one of huge criticism, which appeals to the denying one. While external validation is hugely appealing, it is good to take a harder look at how viable certain actions or events are, especially at a time when the talk of a slowdown gets louder, and perhaps shift the focus to internal validation.
Such a slugfest between internal validation and external validation is a constant in the life story of entrepreneurs. In fact, this columnist has written about this earlier too; but nothing beats the current chatter around steep falls in valuations for startups – where the founder knows the internal truth of the company’s performance and toils hard to keep up with the mirage of the external or perceived valuation.
Look for example what’s happening with home-grown edtech startup BYJU’s- one of its investors, Prosus, started to categorise the edtech company as a non-controlling financial investment rather than an associate, as its ownership fell below 10%, recognizing the fair value of its 9.67% stake in BYJU’s at $578 million. This happened amid a drop in tech valuations due to macro headwinds. Even though BYJU’s appears to be valued at $5.97 billion in Prosus’ accounting entry, experts claim that various shareholders may place a different value on a private corporation. Also, the value of shares in the same company may change significantly between a large stakeholder and a minority shareholder.
BYJU’s was valued at $22 billion in its last funding round in October. Now that’s the key- “different shareholders may value a private company differently in their books”. This is not about singling out BYJU’s on oscillating valuations. To be fair, it’s a company with a product, a brand and paying customers.
Aggressive valuations among privately held tech companies are hardly a new phenomenon. Valuing startups has mostly been considered absurdist because most early-stage businesses have no value and VCs frequently say that valuing startups is more art than science. No matter how many rounds of funding they have received, seed-stage startups, having not yet released a product, are most likely worth less than nothing if a rational valuation methodology is used. The seed-stage startup may continue to lose money until a product is released, at which point, it’s possible that revenue will start to generate. It’s not much better for early-stage startups, which are defined by how much business growth they’ve made and not by rounds like Series A or Series B. A seed-stage business has reduced the risk of commercialisation, once it has produced a usable product. A startup must now demonstrate that this new product or service can be developed into a scalable enterprise. Early-stage businesses are still relatively fragile, with no consistency in their income or cash flows, much like seed-stage startups.
A company is deemed to be in the growth or expansion stage, if its operations have established a regular pattern. Traditional valuation tools like a discounted cash flow (DCF) analysis are almost useless without predictability. And this is a huge paradox, as tech startups, which are loss-making, can still find their valuations go 10X, in as little as 6 months.
One of the downsides of tracking a space for very long is that one could almost pre-empt the response. Pose a question to a startup founder on what their revenues are, what explains the jump in valuations, what their forecasts are or what the burn rates are and the response more often than not is, “We are a private company”. Now, ask an investor how they justify the valuation of an investee company and their response goes “The value lies in the eyes of the beholder”.
The cycle comes and goes. Questions get raised around the absurdly high valuations, startups still raise money to burn money on board meetings approved by VCs and journalists end up looking foolish. It’s about time that there is acceptance towards the fact that the playbook for valuing these startups is different. In the hope of cashing in on the next unicorn, private market investors continue to pour money into tech-based businesses. However, many of these startups have yet to generate a positive net income. And several of them have even reported quarterly losses, that are now in the millions of dollars. What makes it worse is that many of these enterprises don’t have definite plans on how to generate revenue from their operations. To the trained eye, this must raise eyebrows: how could a company be worth billions of dollars, when it’s losing hundreds of millions of dollars every quarter? Many of these valuations are primarily driven by intangible assets and putting a dollar figure on these assets is both an art and a science.
Many of these startups are still developing. To grow, they’re investing heavily in assets, hiring staff, creating cutting-edge tech and promoting their brand through advertising and marketing. They may be making some money, but because they’re scaling up, they may be spending more than they are making. The potential of intangible assets being developed is sometimes more important to investors in these pre-IPO startups than their existing value. And the million-dollar question here is how much they will be able to profit in the future from the new tech they’re developing or the customer base they’re amassing. Investors may be basing a startup’s value on the revenue multiple that it makes. It may be easier to understand what startups can do as complex entities when you pay attention to revenue rather than its intangible assets. Investors typically anticipate that when a startup grows, revenue will keep increasing and expenses remain constant, leading to eventual profitability.
Cycles will go on. The era of cheap money will come and go. But time and again, founders, who stuck to Econ 101, built their companies with frugal capital and are truthful about the internal performance of the company, prove to be winners. Sometimes, it pays for startups to care for internal validation.
Shrija Agrawal is a business journalist who has covered startups and private capital markets before it was considered cool in India
The views expressed are personal
