Since the launch of Startup India campaign in 2016, India has become a hub for start-ups over the recent years due to high growth rates and other factors. According to the Economic Survey Report 2022-23, the number of recognized startups has increased to 84,012 in 2022 from 452 in 2016. India has the 3rd largest startup ecosystem in the world, and it is predicted that it would expand by 12–15% annually on average over the next year. Over the course of the year, number of recognized startups in the nation has risen to approximately 89000 which generated around 6-7 lakhs jobs.
Valuation of startups is a widespread debate in the startup ecosystem in India as well as in other nations. The question is whether the value of shares is correct or inflated or is it the undervalued share with intrinsic opportunity for multi-bagger?
The issue of over valuation arises when investors place a larger value on a startup than it is actually worth, often driven by speculation and hype rather than actual financial performance. This often leads to inflated expectations for startups and can result in challenges for founders to raise capital or make a successful exit. The infusion of funding from venture capitalists and private equity companies, as well as rivalry to invest in high-growth businesses, has contributed to the overvaluation of startups in India.
Valuing a startup is a complicated and methodical process of financial management, projections and discounting of future cash flows, while keeping in mind the competitive positioning of the Startup. In contrast to valuing mature firms, where valuations are supported by historical data regarding the company’s performance, valuing a startup frequently depends on revenue estimates and projections with little concrete facts to support it. This makes determining a startup’s value an extremely challenging task.
Why are some Startups overvalued?
The higher the valuation of a startup, the better it is to grab potential investors’ attention. High valuations signal a company’s success and future; they draw in new clients and employees; and they enhance its reputation. Startups set an aggressive valuation by exaggerating its expectations and wait for investors to jump in even though they are running into losses. Investors are attracted based on the business plan, team profile, their experience, industry knowledge, use of technology, and the market potential for the proposed products or services.
The value of a startup is a crucial factor in any circumstance. Higher valuations allow founders to keep more of their company’s equity rather than diluting it, which improves returns for investors. Lower valuation implies giving up more equity to attract funding.
Startups typically require a lot of funding to sell their products and increase market share due to their innovative nature. Until the startup’s net cash flow turns positive, this requirement will persist.
As the number of funding rounds rises, an increasing number of shares gradually transfer from the founders to the investors. In such cases, the founders naturally have a tendency to regulate the amount of transferred shares.
On the contrary, the founders find it impossible to lower the required funds needed to meet the startup’s growth goals. By overvaluing, they inevitably seek to divert fewer stakes to the investors. As a result, businesses increase their values in order to raise more money for lower dilution of their company.
Investors on the other hand due to the fear of missing out on the larger profits what we call as FOMO, places a higher value on the startups. One of the most important industries in India and a major source of export earnings is the IT sector. We all know that there is no sector of the modern economy that is unaffected by technology and does not rely on it to perform efficiently. They are often asset light since no substantial capital expenditures are spent as their major focus is on delivering services, allowing them to create excellent profitability and return ratios for investors. Investors prefer to congregate around such speculative chances in order to avoid becoming the only person in the area to miss out on the “next great thing.”
Examples of overvaluation in Indian startups/ companies include: There have been multiple cases of overvaluation in Indian startups, when the company’s market capitalization or valuation was thought to be greater than its true worth. Here are a couple of such examples:
Paytm: The largest IPO in 2021, which was also the largest IPO ever in the history of the Indian IPO market was One 97 Communications (Paytm). The Indian digital payments and financial services company was valued at $20 billion when it opened its subscription in 2021.It turned out to be the worst performing initial public offering (IPO) launched in the recent past eroding over 70 % of investors’ wealth since its IPO.
Zomato: An Indian multinational restaurant aggregator and food delivery company Zomato was oversubscribed 35 times, giving it a valuation of $12 billion, but has struggled to turn a profit and has seen its market value decline since then.
WeWork: The office space sharing company was valued at $47 billion in 2019, but later had to withdraw its IPO due to concerns about its profitability and business model.
LIC: Life Insurance Corporation of India (LIC), with a Rs 21,000 crore issue size, was the biggest IPO of 2022. However, it did not live up to investors’ expectations, as the stock has dropped around 28% since its initial public offering.
These are a few examples of overvaluation in startups, but there are many others. Overvaluation can be a major challenge for startups, as it can result in unrealistic expectations and make it more difficult to raise capital or make a successful exit.
Overvaluation, on the other hand, is not always a bad thing for startups. It may provide startups the funding they require to expand and improve their goods and service. Furthermore, overvaluation may be an indication of investor trust in a certain business, which may help it draw in additional capital and talent.
Ultimately, mitigating overvaluation requires ensuring that valuations are based on accurate and realistic financial estimates, as well as a full grasp of the company’s market and growth prospects.
– Shreya Gupta & Priyanka Sharma
Investment Banking Team