The secrets behind the valuation of the tech startup!
What makes a startup a unicorn (valuation of $1 billion or more) within a couple of years after starting the business? What is the reason why the valuation jumped between $5 and $15 billion in just one year? How is a startup valued?
If you’re a finance geek or someone with an unrelated field, all people are confused by these queries. I want to try and unravel these questions and put my thoughts on the subject. I would categorize this in broad terms in the following manner:
The growth: Howard Marks beautifully describes in his note that at no time in the history of humanity has it been possible for startups to grow so quickly and effortlessly with such incredible capital efficiency. To understand what he is saying, we will compare a technology startup with an old-fashioned industry: India’s most prominent FMCG firm HUL (a part of UK giant Unilever Plc) and grocery startup Big Basket. HUL is India’s most prestigious FMCG business, with over 85 years of existence. In March 2021, there were 4500 distributors and 8 million stores that sold its products and generated annual revenue of $6 billion. In comparison, Big Basket, a 6-year-old business founded in 2006, was selling “only” groceries worth $ 1.1 billion without distribution or physical stores in 2021!
Additionally, what’s mind-blowing is the time they took to reach this point. Their revenues increased from 200 million dollars up to $1.1 billion in three years, with their previous year’s revenues doubling because of covid-19. The rapid growth of Big Basket was made possible by the change in its users from 7.6 million a year before to 25 million now. This massive increase in revenue was apparent throughout the startup’s ecosystem because of the increased adoption of digital technology and widespread internet access over the last few years. The covid-19 epidemic also aided digital adoption. India’s number of smartphone users increased from 304 million in 2016 to nearly 700 million by 2021. The covid-19 epidemic has not just boosted digital usage but also led to an enormous increase in screen usage, with Indian users spending 80 percent greater time (more than 4 hours per day) using smartphone apps each day in Q1 2021, contrasted to the first quarter of 2019. With the number of smartphone users expected to grow to over 1 billion in 2025, we can wish to continue to see startups’ revenue rise exponentially in the coming years. The income that these startups generate is not expensive, and they can increase and do so without spending as traditional companies do.
Loyalty: Although startups have managed to increase their user base dramatically, however, the more important question is, are their customers committed to them? Businesses that have been around for a long time have built loyalty through developing trust for decades. Do you think that the ease of purchasing your phone brings customers to these new startups? When a new company comes to market, there will soon be newer ones that offer better prices and even better service, keeping your customers the most challenging task for the latest startups. Specific industries require emotional connection, which is why loyalty is the primary goal for these industries. Let’s take the case of dating apps to understand this. The dating apps industry was home to 250 million and revenues of $3 billion by 2020. The industry has changed in the past and is now using AI to offer guidance or suggestions to their users regarding whether they should take a first date with someone they’ve met on the internet. People can be highly emotionally involved in their relationships. If a “loyal” customer encounters an inappropriate meeting (arranged via AI), the person could move away from the specific app and move to other apps. Startups must be careful when emotions are at play.
The ability to earn money and the mature phase saturation: While most startups have been able to boost their revenues by a significant amount, only a few are financially viable or on the way to transforming their businesses. They burn a massive sum of cash each calendar year (burn rates) to increase their user base and revenue (offering huge discounts). If we look at the case from Big Basket discussed earlier, their losses have increased from $37 million during FY2018 to $96 million in FY2020. The basic strategy is to invest in growth and eventually become the market leader within one’s sector and become profitable to increase shareholders’ value. To better understand this, let’s consider Facebook’s example: Facebook took five years to make money and was not financially viable when it floated. It later became one of the most profitable companies. Profitability can also be attributed to the level of saturation where startups are operating or referred to as a mature stage within the business cycle. After the fierce competition is over and the business has grown significantly with just a handful of players remaining, the profit margins begin to increase, and shareholders receive substantial gains on their investment. The road to profit is a long one for most companies starting and testing investors’ patience in VC/Angel/PE. Since only a handful of businesses remain in existence until the market is saturated, most companies are acquired by large companies or shut down due to over-compliance during this growth stage. The right company to bet on is a Hercules task for investors. We’ve seen numerous instances when investors burned their fingers. The path to profit is complex, uncertain, and only a handful of lucky winners are in the final.
Disruptive Tech Disruptive Tech: A few of these companies have changed our daily lives. These are the businesses that have been at the forefront of innovation and have disrupted our society’s way. One of the strengths of these firms is that they create products that are affordable and accessible to a larger audience. They promote the idea of “ease of living.” We can appreciate the disruptive impact of technology by knowing how ridesharing apps have changed our lives. Uber 2009 launched the concept of ridesharing apps which marked a significant difference from “normal” hiring taxi drivers for your ride. These ridesharing apps developed the opportunity to connect users with drivers of cars available for hire. The concept was a massive hit in the market, and 12 years later, after its introduction, ridesharing apps will bring in $258 billion by 2021. the potential for significant growth is yet to be seen as the use rate is 19.7 percent. Although there are many challenges to overcome, sharing applications have dramatically changed our travel habits. Innovative technology creates a lot of value for investors because it provides a profitable revenue stream that lasts for an extended period of super growth.
The power of Data Clive Humby said in 2006: “Data is the new oil. It’s valuable but not refined, and it can’t be utilized. It needs to be transformed into plastic, gas chemical, etc. to form a useful entity that can drive profitable business Data must be broken downand analyzed to be valuable.” In recent times, startups have realized the value of data. Most of them use data to expand their businesses and customize processes or refine them to enhance customers’ experience. Many startups employ AI (Artificial Intelligence) and ML (Machine Learning) to refine the vast amount of raw or unstructured data and extract valuable information with time. Even though oil is a renewable resource that is declining each day, Data is a resource that is infinite and growing exponentially with each passing second. With the increase in internet and smartphone use in the next few decades, the volume of data produced is overwhelming. Those who can tap into the power of data and grow their business through it will become the powerhouse of digital technology in the future.
Cyberattacks and privacy The most significant threats for tech startups that have emerged in recent times are cyberattacks and privacy. Most users unintentionally provide a large amount of personal data when they register for tech-related apps. Additionally, these apps also monitor their users’ activities across other applications that are not known to users. This is a process known as profiling. It is employed by many businesses with the aid of AI to improve their products and improve the experience for customers. Throughout the entire process, it is the security of the customer at risk. Suppose there’s a cyberattack or hack of servers. In that case, lots of personal information, including sensitive financial data, is released, which causes a lot of damage to the customers and embarrassment for the company. Startups must consider customers’ privacy and invest a lot of money and time in the security of their systems toto become successful and have a high valuation over the long run. With more people becoming conscious of their privacy rights, tech companies must strive to earn users’ trust and ease the privacy concerns surrounding the technology space.
Value Metrics: Valuing a technology startup is problematic since these businesses are mainly devoid of physical or non-tangible resources. The only assets they have are their ideas, their strategic position in the market, and the people capital of their teams. A mathematically similar approach is employed to assess the value of these startups. Because startups consume lots of cash and have negative earnings during their first period of rapid growth, the P/S (Price to Sales) valuation method is utilized. It is a multiple that is calculated by dividing the stock price by the number of shares sold. Since the revenue/sales rise rapidly in the beginning when multiple contracts are in place, the value increases to maintain the original multiple. But during the dot-com bubble, a handful of firms used this type of numerous. These companies committed illegal practices like bartering advertising on websites with other businesses. Therefore, investors must observe the management’s actions and intentions before investing their funds into these companies.
The craze for startups that have taken over the entire financial world will be around for the foreseeable years. But, there are only a handful of winners at the end of this boom. These giant companies will be able to command incredibly high valuations since they enjoy a loyal customer base, massively lucrative operations, and a considerable amount of innumerable information.
