Reliance Industries is valued at ₹17 lakh crores. That’s 17 followed by 12 zeros! The company is 49 years old. This means Reliance has grown at a staggering 86% every year.
Zepto, the two-year-old grocery delivery startup, was last valued at $900 million, which is about ₹7.44 thousand crores.
There’s been plenty of talk around town about inflated valuations and bubbles, but there’s got to be a method to this madness, right? To say these growth rates are higher than normal would be gross understatement.
Does Zepto have stronger fundamentals than Reliance? Or is there a bigger mystery at play here?
Startups vs Listed Cos
For listed companies, either a Discounted Cash Flow (DCF) method which takes into account the cash flow of a company, or a comparative method which compares price to earnings ratios of similar companies is used.
For startups, these become irrelevant because most startups are loss-making for a long time before they begin to generate any cash flow.
As a result, we’re forced to get creative!
In the words of Paul Graham, co-founder of Y Combinator, “When someone buys shares in a company, that implicitly establishes a value for it. If someone pays $20,000 for 10% of a company, the company is in theory worth $200,000. I say "in theory" because in early stage investing, valuations are voodoo. As a company gets more established, its valuation gets closer to an actual market value. But in a newly founded startup, the valuation number is just an artifact of the respective contributions of everyone involved.”
What stage is the startup at?
A large part of startup fundraising depends on what stage a startup is at.
In case of early-stage startups that don’t yet have a stream of revenue, investments often tend to happen at standardized ranges. For instance, a particular venture capital firm investing in early-stage startups could offer fixed investments of ₹50 lakh in exchange for at least 10% of equity.
Now, let’s consider the example of two startups in the consumer goods space. Their products are similar. They are both in the prototype phase. But while the first startup has a fully functional prototype, the second one has a prototype along with an existing community or network of users.
The latter startup would probably get the better deal.
Is there a method to this madness?
Once startups start generating a steady stream of revenue, the way a startup is valued by investors may change. A common method is to use the market multiple, which compares the startup against other similarly sized startups in the same industry.
The first step in this case is identifying a group of similar companies in the same industry and then looking at various financial metrics such as revenue to calculate a multiple that represents their valuation. This multiple is typically the ratio of the company's market value to the financial metric you're using.
For example, if a large edtech company is currently valued at 10 times their revenue, that serves as a starting point for the sector, adjusted upwards or downwards depending on size of the company and the potential upside.
Investors bet on future potential
It took Amazon nearly a decade to turn a profit, so when you see valuations of loss-making startups go up with each new funding round, remember that they are all betting on future potential.
Valuation techniques enable investors to make informed decisions. But the data only supports the inference that the investor draws.
There is only one question that matters — Can this startup make money for investors?
Case in point startups that raise money on the basis of an idea, and maybe a stellar team of people willing to execute it.
We can talk about valuation methodologies all day long, it often boils down to what the founders and the investors agree upon. They are in it for the long haul, and a potentially big payout if the company becomes successful enough for a liquidity event that benefits one and all.