Thursday, February 22, 2024

Why startup valuations are tumbling

Startup funding, which tends to alternate between periods of feast and famine, is firmly in famine territory at the moment. In 2021, a new Indian unicorn was being minted almost every week. There was plenty of funding available for any startup with a seemingly coherent business plan and competent founders.

In 2022, funding for Indian startups dropped 38% to $28 billion, from $33.7 billion in the boom year. Only 22 unicorns minted that year, compared to 43 in 2021. There were only 14 IPOs in 2022, with an average market cap of $463 million. In 2021, 18 IPOs generated an average market cap of over $4 billion. The number and value of acquisitions also fell. The average acquisition price in 2022 was $70 million, down from $118 million in 2021.

January-March 2023 saw even steeper falls. Indian startups raised only $2.9 billion, 75% less than the $11.9 billion they raised in the same quarter last year. No startup has yet turned unicorn in 2023.

Moreover, the valuations of existing unicorns have been written down sharply. Byju’s, for example, was revalued at $5.8 billion in November 2022, which was 73% less than its peak valuation of $22 billion. Swiggy’s valuation was cut to $5.5 billion, a 45% drop from its peak. Ola’s was slashed to $4.8 billion from a peak of $10 billion. Oyo, which was also in the $10 billion ballpark, is now valued at $2.7 billion. Pharmeasy, too, is down from $5.6 billion to $4.4 billion.

These are the big boys of India’s startup ecosystem. The devastation in valuations of smaller startups is even worse. What’s more, venture-capital and private-equity investors are taking far longer to close deals while offering smaller sums for larger stakes. So what’s going on?

The first thing to note is that these valuations, are to some extent, just guesstimates of what these businesses are worth. Startup benchmarks are largely derived from variations on the following calculation: Let’s say startup “X” offers a 10% stake to VCs for $92 million. This means 1% of X is worth $9.2 million and thus X is valued at $920 million.If it receives a different sum for a different stake in the next round of funding, the valuation changes again.

While it’s normal to use valuations from the latest funding round, VCs also periodically review what each holding is worth and set their own valuations if the last round of funding was a while ago. When VCs file statements with the US Securities and Exchange Commission (SEC) saying that valuations have fallen, it means the next round of funding will probably feature lower valuations. If a startup is looking at launching an IPO in such an environment, it will also be at a lower valuation.

Contrast this guesswork with valuations of listed companies. Financial reporting standards are far more stringent for public companies, and their valuations are usually closely linked to revenue and profitability.

So why do startup valuations fall? Disappointing business performance isn’t necessarily the reason, as most startups remain unprofitable for years. Flipkart, Zomato and Paytm are some examples. Nykaa and Mamaearth are perhaps the only profitable Indian unicorns (Swiggy claims it was profitable in March 2023). So a lack of profits isn’t enough to justify a valuation downgrade.

The sharpest falls in startup valuations are in fact not driven by poor business performance. Valuations are correlated to the cost of money – i.e., interest rates. If rates are high and money scarce, investors tend to shun high-risk businesses. Indeed, many even ditch listed companies and stockmarkets altogether and head for the safety of fixed-income instruments.

In late February 2022, the Ukraine war sent the global economy into a tailspin. The prices of fuels skyrocketed and supply chains were disrupted in industrial metals, semiconductors, paper, industrial gases and even food grains. Inflation spiked around the world.

Central banks responded by raising policy rates. The rupee lost ground versus the US dollar, which further stoked inflation as imports became more expensive. You may note that the valuation data above is also in US dollars. That’s because a large proportion of investments are dollar-denominated ones from abroad.

As interest rates climbed and the rupee fell, investors started shunning high-risk investments and causing the entire startup ecosystem to suffer. Until rates level off or start falling again, valuations are unlikely to recover.

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