Startup valuations through investors’ lens

Valuing early-stage startups is based on innovation, growth potential, market dynamics, and the power of a capable team. As investors navigate this narrative, they find themselves equipped to make informed decisions in a landscape brimming with opportunities and challenges.

Startup valuations through investors’ lens

Wednesday September 20, 2023,

5 min Read

In the post-COVID era, India’s startup scene experienced significant growth. According to The Indian Tech Unicorn Report by Orios Ventures Partners, 46 unicorns emerged in 2021 alone, showcasing India’s thriving entrepreneurial landscape and promises it holds for the future of innovation.

Another report by Iron Pillar states that by 2025 India could have up to 250 unicorn, positioning it as the third-largest contributor to global unicorn numbers. This projection underscores India's rapidly advancing startup ecosystem, recognised for its innovation, economic impact, and global significance.

Yet, amidst the excitement and potential, a critical challenge loomed—how to accurately value early-stage startups? Investors, eager to make informed decisions, found themselves navigating uncharted territory. The need for robust valuation methods had become paramount, guiding them through the intricate landscape of startup valuation.

Let’s dive deeper into the essence of a startup. Startups stand out for innovation, solving problems creatively. Their growth potential lies in addressing market gaps and capturing untapped demand. Early on, profits are secondary; they prioritise market penetration, investing in research, marketing, and adaptability to thrive in changing markets and trends.

Funding and growth stages

At the heart of the startup’s narrative lie pivotal funding rounds that align with its evolution. These funding stages not only infuse capital, but also signify key milestones in the startup’s journey.

1. Seed Round: $10,000 to $2 million

The seed round marks the startup's inception, channelling initial capital to crystallise ideas, conduct research, and establish foundations.

2. Series A: $2 million to $15 million

Series A funding propels startups from concept to reality. It fuels initial operations, scaling teams,  and optimising business models.

3. Series B and above: $15 million to $30 million

Series B turbocharges growth. It empowers startups to build robust teams, chase ambitious goals, and expand market presence.

Typical Business's Journey: As startups evolve through funding rounds—from seed to series A, B, and beyond, their valuations rise in tandem with milestones achieved. Challenges in longevity underline the harsh reality; many startups don't cross certain milestones, highlighting the importance of thorough evaluation.

All this gives rise to three fundamental theses in terms of investing in a startup:

a)     Invest in great business

b)     Run by great founders

c)     Available at fair valuation

Scale of startup & valuation complexity due to lack of data, uncertainty

The journey of startup valuation is intertwined with their growth stages. Interestingly, the maturity of a startup and the difficulty of valuing it are inversely connected. Mature companies tend to be more easily valued due to established track records, while early-stage startups pose valuation challenges.

Valuing mature companies tend to be easier and more scientific, whilst valuing early-stage

companies is ‘more art’.

Why is valuing startups “more art”?

a)     Minimal historical data has a bearing on benchmarking forecasts.

b)     Most companies are not publicly traded, making it challenging to asses the risk profile.

c)     Limited comparable companies and transactions to benchmark performance and value.

d)     Existing assets represent a small proportion of the overall valuation.

Traditional valuation methods may not be used when valuing startups

a)     Discounted cashflow method—Estimated future cash flows over a certain period x discount rate (risk beta).

b)     Trading Multiples—Usually valued as a multiple of Revenue, EBITDA, Earnings Per Share, EBIT, etc.

c)     Precedent Transaction—Precedent transaction analysis is a valuation method in which the price paid for similar companies in the past is considered an indicator of a company’s value.

How do we value startups then?

Market competition and entry barriers: Product differentiation, market crowding, and entry barriers play pivotal roles. Uniqueness sparks a competitive edge, while barriers influence entry ease.

Market Viability: Does the product resonate with the market’s needs? Gauging the startup’s potential to secure a meaningful market share is vital.

Revenue Model and Lifecycle: The startup’s revenue model takes center stage—does it rely on recurring revenue streams or one-time transactions?

Traction and Customer Metrics: Even with limited historical data, traction metrics offer valuable insights. Customer growth and retention rates reveal the startup's market acceptance.

Financial Analysis and Business Goals: Peeking into the startup’s financials unveils its past expenditure and future plans. Evaluating the path to profitability and near-term objectives sheds light on their strategy.

TAM, SAM, and SOM: TAM represents the entire market demand for a product or service. SAM is a subset within reach, while SOM is the share the startup can capture.

Team: with relevant skillset and execution capabilities.

Funding winter in startups: In the past year, global economic challenges like rising interest rates have adversely affected startup growth. A report by GlobalData highlights a significant drop in VC deals, with only 459 deals totaling $3.4 billion in the first five months of 2023, compared to 851 deals worth $13.3 billion in the same period a year earlier.

Notably, PE/VC in India experienced a substantial decline, plummeting by 75% in the first quarter of 2023. This stands in stark contrast to a country that had birthed 20 unicorn startups in the initial nine months of 2022 but has seen only one unicorn emerge in 2023, namely Zepto.

These harsh conditions have led investors to become more cautious with their startup investments & shift their focus from growth to profitability.

A glimpse of hope

August brought some hope, as funding activity saw a resurgence. There were 35 private equity and VC deals, totalling $2.7 billion, a significant increase from July's $1.8 billion and even surpassing August 2022's $2.3 billion, according to Venture Intelligence.

To summarise, the story of valuing early-stage startups is based on innovation, growth potential, market dynamics, and the power of a capable team. As investors navigate this narrative, they find themselves equipped to make informed decisions in a landscape brimming with opportunities and challenges. The journey continues, one valuation at a time.

(Vikram Ramasubramanian is a Partner at Inflection Point Ventures)

Edited by Megha Reddy

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)