Why Startups Need To Get The Basics Of Valuation Right Now More Than Ever

According to CB Insights, global funding to startups fell by 23% in the second quarter of this year, and the number of deals fell by 15%. It marks the biggest quarterly percentage drop in deals and the second-largest drop in funding in a decade. 

This slowdown can also be seen in India. The funding raised in the Q3 of 2022 was 82% lower than the historical $17.1 Bn raised in Q3 of 2021 by Indian startups. The pace of startup investments has come down, but that isn’t necessarily bad. It could be viewed as a sign of investor maturity.

Getting Valuations Right

Earlier, venture capitalists and corporate venture capitalists (CVCs) had the fear of missing out on the next big startup. They were liberal with their funding, which often led to high startup valuations. 

Valuation is not an exact science. It’s part science and part art. 

At the initial stage of investing, an investor will look at how the startup team functions. They will consider the market size and competitive landscape, as well as the startup founder’s ability to execute. Sure, there are metrics such as discounted cash flow or a formula-based approach to determining the valuation. However, at the end of the day, an investment position is taken based on an incomplete understanding of the risks and finances. 

Research by the Kauffman Foundation points out that venture capital investments have delivered poor returns for more than a decade. Their returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in venture capital.

Today’s venture capitalists are rethinking their funding methods, and young startups must consider this mindset change. 

Adapting To Changing Investor Mindsets

Venture capitalists and corporates are now questioning startup founders about their execution strategy. They are asked to demonstrate a path to profitability and show how cash flow can be managed. 

As investors become prudent with their investment choices, they are also experimenting with newer ways to make investment decisions. Gartner forecasts that by 2025, 75% of venture capitalists will be using Artificial Intelligence (AI) over their ‘gut feel’ to make investment decisions. They will use data to track down companies that are on the verge of becoming successful. Some are already doing it.

Despite the slowing pace of investments, reports indicate that investments are still being made by venture capitalists and CVCs. Both have turned selective, focused on innovative technology, and are diligent before making funding decisions. The technology landscape is changing, and they are looking towards innovative startups for solutions.

Some startup founders are also sensing this shift in the tide. They are carefully examining their growth options and recalibrating their growth plans. This shift in startup and venture capitalist funding strategies is ultimately beneficial to the overall innovation ecosystem. 

Both are realising that revenue is vanity, but a steady cash flow is a reality. Perhaps, the days of inflated startup valuations are coming to an end.

Focusing On The Fundamentals

Startups need to focus on getting their fundamental unit economics, customer acquisition costs and lifetime valuation right. They should get these metrics right for the business they run. It’s key to being valued correctly. An overvaluation can be detrimental to the startup, the investors, and the overall economy. 

India is currently home to 107 unicorns with a total valuation of $340.79 Bn. However, data suggests that only 23 of these unicorns, startups valued at $1 Bn or more, are profitable. Some of them were listed on the stock exchange but fell below their Initial Public Offering (IPO) prices, which suggests that the markets were sceptical about their high valuations. 

For a young startup, overvaluation will pose challenges when moving to its second round of funding. The investors will take a closer look at the fundamentals. If overvalued, the startup will not be looked upon favourably and the second round of funding will be unsuccessful.

The post-pandemic recovery presents young startups with a unique growth opportunity. The focus of a young and emerging startup should be on building a good business, with strong ideas, fundamentals, and execution of profitability plans and cash-flow metrics.

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.