The startup world is currently experiencing an investing winter, with high valuations and limited access to cheap capital putting pressure on entrepreneurs and investors alike.
The past decade had seen a surge in startup investment, driven by easy access to cheap capital and a wave of disruptive technologies. This shift marks a significant change from the investment landscape of recent years, when companies with little to no revenue could raise massive sums of money at sky-high valuations.
The world of startups is often characterised by explosive growth, ambitious goals, and staggering valuations. Every day, new companies with promising ideas and a charismatic founder (or two many) emerge, and they are quickly swept up in the world of private investors and angel investors who are eager to invest in the next big thing. That first funding cheque is a true catalyst for many of the successful founders. It is an external stakeholder acceptance of an idea that could potentially make money - what family and friends do as encouragement, but don’t ask those tough questions.
Valuation has always been a hot topic in the startup world. Founders often view a high valuation as a sign of success, but the reality is that it can be a mirage, especially in times of investing winter. But then, the Startup valuations are often a mirage, while consumer stickiness and profits are the real indicators of success. The traditional valuation metrics of revenue and earnings had been replaced by more subjective measures, such as user growth and potential market size. This allowed many companies to raise significant sums of money without showing a clear path to profitability, but it has also led to a bubble in startup valuations.
When the going is good, most will accept the valuations at face value. When the music stops or slows, everyone suddenly has questions - right from business viability to cash flow discounting rate to discounting methodology to intent of founder to actual size of the consumer market.
Startup valuations are essentially a measure of how much investors are willing to pay for a piece of a company, at that point of time.
“Price is what you pay, value is what you get”—Warren Buffet
Valuations are typically based on a company’s potential future earnings, rather than its current revenue or profits. This means that a company with little or no revenue can still be valued in the millions or even billions of dollars, simply because investors believe that it has the potential to become a massive success. Investors are essentially making a bet on the company’s future success, and there is no guarantee that this success will actually materialise. In fact, the vast majority of startups fail, which means that the investors who invested money into them will see little or no return on their investment.
Startup valuations can also create a misleading signals for both investors and founders. When a company’s valuation is based on FOMO, and easy funding monies available, it can create a sense of unrealistic expectations. Founders may feel pressure to deliver on these expectations, even if it means sacrificing long-term sustainability or ethical practices. Investors may also feel pressure to invest in companies that have high valuations, even if they are not convinced that the company has a solid business plan or sustainable revenue stream.
“Ultimately an investment is an instrument of trust as much as it is of belief”— Henry Joseph-Grant
In addition, high valuations can create a sense of entitlement among founders. When a founder's net worth is suddenly in the millions or billions of dollars, it can be easy for them to lose sight of their original vision and become more focused on personal gain.
This can lead to a culture of excess and frivolity, which can ultimately harm the Company’s long-term prospects. It is common to see many a founders (even if their own business valuation is not so high), spending their time and money in Angel investing as a branding and investment diversification exercise. Seldom do their investors ask if they could devote that time and energies in turning around their core startup !
“The numbers should speak for themselves, but they don’t. Growth metrics are the misunderstood teenagers of the tech world with murky intentions” — Molly Norris Walker
Furthermore, high valuations can create a bubble in the startup ecosystem. When investors are willing to pay exorbitant prices for companies, it can create a sense of irrational exuberance and a rush to invest in any company that has even a hint of potential. This can lead to a situation where there are too many startups chasing too few investment dollars, which can ultimately lead to a market correction.
On the other hand, profits are a much more concrete indicator of a company’s success. A profitable company is one that is generating real revenue and providing real value to its customers. It is a company that has proven its ability to deliver a product or service that people are willing to pay for, and it is one that has a sustainable business model that will allow it to continue generating profits over the long term. Of course, profits are not easy to come by, especially for startups. Many companies operate at a loss for years before finally turning a profit, and some never do. However, when a company does start generating profits, it is a clear sign that it has found a sustainable business model and that it is providing real value to its customers.
Is this why founders, who are otherwise balancing multiple stakeholders and business objectives, see valuations as a business mirage? An image they think they are, but which does not exist! Also does the peer pressure or media pressure or even the policy pressure of declaring Unicorns as a success indicator put the wrong metric ahead for the founders?
During an investing slowdown, as we are seeing now, investors are more cautious about where they put their money. They are less likely to invest in companies with high valuations, as they are often seen as overvalued and risky. This can be particularly challenging for founders who have focused on achieving a high valuation as a measure of success. When the market turns, they may find themselves struggling to secure funding, or having to accept unfavourable terms to do so.
Moreover, a high valuation can create unrealistic expectations for a startup. It can lead to a focus on short-term growth at the expense of long-term sustainability. Founders may feel pressure to prioritise metrics that will help them achieve a high valuation quickly, such as user acquisition or revenue growth, rather than building a strong foundation for their business. In the long run, this approach can be damaging. A company may grow quickly in the short term, but if it has not focused on sustainable growth, it may not be able to maintain that growth in the long term. This can lead to a cycle of raising more and more money to keep up with expectations, and ultimately, to a company that is not viable.
Instead of focusing on achieving a high valuation, founders should focus on building a sustainable business that can weather the ups and downs of the market. This means focusing on metrics that are important for long-term success, such as customer retention, profitability, and market fit. By prioritising sustainable growth over short-term metrics, founders can build a company that is attractive to investors in any market. Investing winter is a sign of a maturing startup ecosystem. It is a reminder that success is not guaranteed, and that companies must focus on building sustainable businesses that can survive in any market conditions. While it may be a challenging time for startups, it is also an opportunity to build stronger, more resilient companies that can thrive in the long run.
—The author, Dr. Srinath Sridharan, is a Policy Researcher & Corporate Advisor. He has also author of the book 'Time for Bharat'. The views expressed are personal.
Read his previous articles here
(Edited by : C H Unnikrishnan)
First Published: May 20, 2023 11:55 AM IST
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