The Irony of Startups: It\’s pouring funds, with Negative Earnings

  • As of 4th December 2021, India has 82 unicorns with total funding of $38.4 billion (2014 onwards) (source: Inc.42)
  • In Q3 2021, Indian startups received $10.9 billion of funding across 347 deals (Source: PwC India)
  • As per research, globally around 70% of startups fail — usually around 20 months after first raising financing, with around $1.3M in total funding closed (Source: CBI Insights)
  • Despite being unprofitable, Groww (a wealth management and investment platform), tripled its valuation to $3 billion after a $251 million funding in October 2021. On the other hand, profit making Zerodha, one of its major rivals, is not even near in the valuation, being a bootstrapped company.
  • With heaps of losses, Cars24 is valued at $1.75 billion, after a $450 million funding round recently, while profitable CarTrade is not able to even reach the $1 billion mark. 

The above statements are not just some pieces of news, but they showcase the current funding scenario of the startup world. 

It’s pouring funds for startups, despite being unprofitable. Startups are unapologetic about their losses or no near-term profitability roadmap, rather they are exhibiting their long-term vision, disruptive solutions and technology to attract investors and raising loads of funds. 

Also, investors are putting their hard-earned money in such startups, with the belief that the company has the potential to be significant. Of course, investing in such businesses can be risky, but the potential rewards make the bet worthy. 

The Funding Frenzy

There is a mad rush for raising funds. Be it the founders of a startup or the venture capitalists or the angel investors, all are actively involved in this funding game. 

Founders promise high revenues in their companies while pitching for funds. However, there is no surety of operating profits even in the near future. This gives them an incentive to create fictitious revenues or even change the matrices of revenues (e.g. Gross Merchandise Value or the value of goods sold rather than Actual Revenues), thus attracting follow up investments. Sometimes, they even try to pursue investors in the short term on the premise of scale rather than top line growth. 

Stories are Sellers: Founders who are raising funds are, to say the least, great storytellers. Many have identified the recipe for raising funds is a great story. Whatever the business, package it well with some punk design and language, add a bit of technology, a beautiful website/app, some story around how it will scale and there you go. The pitch is ready for your game. Think of a startup selling “Chai\’\’ or “Momo” or “Paratha”. The franchise barely ensures the same taste and everything is outsourced. But as you say, “In India, there is a Market for everything”.

The Amazon Story: Amazon reported losses in the very next year of getting listed (in 1997). Jeff Bezos reasoned that the company is looking for long time growth in the radar, and not short-term profitability. The company posted its first full year of profit in 2003, i.e., six years after going public. Bezos continued his ‘long term view’ faith and made his investors believe in the same. We all know what Amazon is today. Every start-up in India believes, or at least makes its investor believe, that it will be the next Amazon. Even the investors put in their money expecting the same.

FOMO Effect: The Fear of Missing out (FOMO) can be seen in all; be it the founders or the investors. The founders are raising money, sometimes even if they don’t need it, because their competitors are also raising funds and they don’t want to be left behind. The so-called peer pressure sometimes forces them to go for the next round of funding at a higher valuation. Their sole attention is on getting more funds rather than running the business, leading to a burn-out situation. Founders are often more interested in “Showing high Valuations” rather than “Creating More Value”.

Valuation – Fundamental Projections or Future Expectations

Today, most of the startups are seeing revenues declines, cash crunches and what not. Profitability seems to be a mirage in the desert. Yet we are seeing more and more unicorns added to the ecosystem. Companies are getting very high valuations despite running on losses. 

Some believe that these eyebrow-raising valuations are valid, as these reflect the potential strength of the start-up. While other schools of thought believe that the valuation tag is the prestigious entry to the extravagant funding arena.

The valuation of loss-making companies is based on expectations, rather than fundamental valuations. Factors such as demand for the company’s products/services and how their new ideas are disrupting old businesses may encourage investors to place their money into the firm. Investors/Valuators see growth opportunities because the market is still underpenetrated, hence the high valuations. 

As per CRED CEO, Kunal Shah, “Unicorn tag, high valuation are all vanity metrics till the company delivers profits”.

What’s in for the Investors?

When investing in a startup, VCs and other investors see a great idea, a big opportunity and umpteen potential. There is always an underlying risk as the probability of failure is pretty high in startups. It all started with investors providing some funds to entrepreneurs so they did not have to borrow funds from banks which come with committed cost, so the best bet was to give funds against Equity. Valuation was implied based on funds provided and negotiated stake in equity. But then there is a lot to earn as well, if things work out and the investors can make tons of money. They see the trade-off where companies are forgoing their profits for customer acquisition and creating a brand value for them.

There is always an option to exit: With the listing of Zomato and Paytm, we can say that the exit route for investors is going for an IPO. Great Economist Lord Keynes said, “The Markets can stay irrational longer than you can stay solvent”. As the stock markets have sky-rocketed ignoring the concept of gravity, investors have found a good opportunity to realise their bucks by pushing companies to go for IPOs – their ultimate exit option.

The public route not only provides salvation to the early set of investors, but also an opportunity to retail investors to seize the so called ‘rewarding and worthy money minting machine’, if the startups deliver on their promises. Even the regulator SEBI has allowed loss making companies to get listed, on the premise of 75% investment by institutional investors, protecting the retail investors interest to some extent. 

Investing in unprofitable companies is a high-risk, high reward proposition. However, using an appropriate valuation method and following rational precautions such as assessing risk-reward, evaluating the company’s management strategy, and using a portfolio approach can mitigate the risk of investing in such companies and bear high rewards.