The Rise Of Unicorns: Analysing Valuation Strategies For High-Growth Ventures

In recent years, the tech world has witnessed the meteoric rise of unicorns — privately held companies valued at $1 Bn or more. In 2013, when the term ‘unicorn’ was coined, only 39 companies met this criterion. A decade later in 2023, CB Insights reports that there are over 1,200 unicorns worldwide. 

These high-growth ventures have disrupted industries, redefined business models, and captured the imagination of investors and stakeholders globally. But what lies behind the astounding valuations of these companies?

The Anatomy Of A Unicorn

Unicorns are not merely companies with exceptional valuations; they possess certain defining characteristics that set them apart from the rest, such as:

• Hyper-Growth Potential: Unicorn startups are known for their incredible growth trajectories. They often achieve exponential revenue and user base growth within a relatively short period. For example, Flipkart or Amazon in India have huge growth potential considering the large underserved online commerce vis-à-vis offline transactions. Online commerce penetration is still around 8.5% (as per an article on yourstory.com) in India, with a decade of journey covered.
• Disruptive Innovation: Many unicorns leverage disruptive technologies or business models to challenge existing industries, creating new markets or reshaping existing ones. The best example of this is Uber that completely disrupted the taxi industry globally with its technology-driven approach.
• Scalability: At the core of unicorn’s success is the ability to scale up quickly. They can grow rapidly without a proportionate increase in costs, often due to digital platforms or network effects. SaaS companies, including Zoho, Shopify, and Dropbox, have exhibited exponential scalability with a global outreach.
• Market Leadership: Unicorns aim to dominate their respective markets or niches, becoming leaders in their industries and effectively fending off competition. Meta, for example, holds a near-monopoly in the social media space.
• Global Ambitions: These startups usually have a global vision from the outset, seeking to expand internationally and capture a significant global market share. All the above examples embody the global scalable model.

Valuation Strategies For Unicorn Startups

Unicorns, when it comes to determining their value, are typically assessed using a combination of two distinct methods: market approach and income approach. There is a third method (cost approach) that is ‘NOT’ utilised in valuing unicorns, places reliance on the cost associated with replacing the unicorn’s assets. This method operates on the premise that a company’s value is equivalent to the cost required to replicate its assets. It is applicable when there is a scarcity in data specific to the company being assessed.

The market approach primarily hinges on the use of comparable companies as a reference point to gauge the unicorn’s value. This method operates on the assumption that a company’s worth is akin to that of peers. It proves especially useful when data regarding the specific unicorn under evaluation is limited or scarce.

Some of the metrics used in the valuation of the unicorn are:

• Key Performance Indicators (KPI)-based valuations: KPI-based valuations are often derived by dividing Enterprise Value (EV) by the number of active users (daily or monthly), or dividing EV by Gross Merchandise Value (GMV). These metrics are industry specific and it can vary from one industry to another. For instance, social media may look at the number of active users, fintech-lending company may look at the loan book, ticket size and net interest margin, Car rental platforms, such as Droom, Spinny, and Zoom, may look at number of cars of transactions on the platform.
• Revenue-based multiple: It is calculated by EV/Revenue; EV/Annual Recurring Revenue (ARR); EV/monthly recurring revenue(MRR)*12. Revenue-based multiple is among the key valuation metrics that one typically looks at. This gives a view on the hyper-growth that the company is able to achieve and if it is sustainable or not.
• Earnings Before Interest, Taxes, Depreciation, and Amortization(EBITDA)-based multiples: This is less commonly used since many unicorns are mostly loss-making. This could be typically used on a forward-looking basis.
• Benchmarking the pre-money valuation: Benchmarking the pre-money valuation at a particular round (say Series D) in a similar space to the comparable companies and using the above metrics for evaluation.

Price to Earning (P/E) multiples or cashflow multiples are rarely used. 

If available, the above metrics are derived by comparing the subject company with private company data. Due to its private nature, the data is difficult to find but not impossible. One can conduct thorough research by visiting the Ministry of Company Affairs (MCA) website to obtain private company financials in India. 

Additionally, one can perform secondary and primary research, and use private company databases, such as Pitchbook, CB Insights, Tracxn, and Crunchbase, to figure out comparatives. One can also look at M&A transactions multiples in the space and public company multiples to benchmark if any close competitor has gone public (For example, Zomato is a great comparable for Swiggy’s valuation). Other examples include Paytm, Nykaa, and Policy Bazaar.

Conversely, the income approach, another widely employed method in unicorn valuation, centers on projecting future cash flows to estimate the unicorn’s value. This approach is rooted in the belief that a company’s value equates to the present value of its forthcoming cash flows. 

This method in the purest form (explicit forecast with Gordon growth model for terminal value evaluation) is rarely used in determining the unicorn valuation, unless it is cash flow positive or about to generate sustainable cash flows. However, Discounted cash flow (DCF) with exit multiple method is commonly used where the explicit forecast period is critically evaluated and then an exit multiple in the form of EV/Revenue or EV/EBITDA is applied in the terminal year.

Determining the value of unicorns involves a nuanced blend of these two methods: the market approach, which draws from comparable companies; and the income approach, which extrapolates from future cash flows. Each approach is applied strategically, depending on the availability and quality of data for the unicorn in question.

Challenges In Valuing Unicorn Startups

Valuing unicorn startups has its challenges and risks.

Many unicorns are private and do not disclose detailed financial information. This lack of transparency can make it difficult to accurately plot down valuation. Furthermore, predicting the future growth trajectory of a high-growth startup can be highly speculative. A slight deviation from projected growth rates can significantly impact the valuation. 

Above all, unicorn valuations can be highly sensitive to market conditions. Economic downturns or shifts in investor sentiment can lead to sharp fluctuations in valuation. The current funding winter is a good example of valuation markdowns of multiple unicorns. On the other side, in the hay days (during low interest rate environment), the valuation of unicorns had flourished.

Future Trends 

As the tech ecosystem continues to evolve, unicorn startups will remain a prominent feature. Understanding the valuation strategies behind these high-growth ventures is critical for investors and entrepreneurs alike. 

It is evident that the traditional methods of valuation, relying on loosely defined industry metrics, such as Gross Merchandise Value (GMV), monthly active users (MAUs), and the sheer number of signups, have become antiquated. Presently, investors place a significant emphasis on sustainable growth, the trajectory towards profitability, cash flow dynamics, and the capacity to capture a substantial market share while maintaining positive unit economics.

Anticipating the future, the landscape of valuation may undergo transformations with new methodologies. However, the fundamental tenets of evaluating market potential, assessing competitive advantages, and projecting growth are likely to continue being central pillars.

Unicorns represent a unique phenomenon in the business world, showcasing the power of innovation and ambition. Their valuations reflect their potential to transform industries and create enormous value. As investors engage with these high-growth ventures, a nuanced understanding of valuation strategies will be key to navigating the exciting but challenging world of unicorns.