Why Do Startups With the Highest Valuations Make the Least Profit?

Just because of valuation, startups often take the limelight as unicorns even when they are losing hefty amounts of money. This may seem strange, but older businesses are not regarded as strongly as startups, and in most cases, these existing businesses are valued well below their genuine value.

Every day, businesses of every kind face an unpredicted plethora of threats. It is important to recognize that losses can be either caused by temporary (short-term or medium-term) or some continuous long-term issues.

Unicorns in India, or companies valued at $1 billion or more, are contradicting the traditional wisdom that valuations are based on future earnings. As their losses mount, private investors are compensating them with progressively greater values.
While lots of businesses continue to lose money quarter after quarter, a select handful achieves enormous success and become national brands. The trick, of course, is determining which of these businesses will make the transition to profitability and blue-chip position.

Valuing a loss-making business can be a difficult task. A business with negative earnings or incredibly low earnings is considerably more difficult to appraise than one with positive earnings. In reality, rather than basic assessments, loss-making enterprises are valued primarily on hopes.

In this article, we are going to discuss why we see that startups with the most valuation have the least profit.

Startup Valuation
Why High Valued Startups Have the Least Profit?
Cases of High Valuation Low-Profit Startups

Startup Valuation

In simple words, startup valuation is the way of assessing a firm's value, or valuation. An individual investor in a startup trades for a portion of the company's stock during the seed fundraising round. This is why valuation is crucial for entrepreneurs since it allows them to determine how much ownership they must provide a seed investor in return for their financing. It's also crucial for an investor, who needs to know how much of the company's stock they will get in exchange for the money they put in during the early stages. As a result, startup valuation can be a deal-maker or a deal-breaker, which is why it does not include any speculation based on the valuation of other comparable businesses.

Furthermore, before assessing a firm's real worth, creators must have a thorough understanding of how the entire startup valuation process works. If there is little to no revenue-generating, founders tend to quote an excessively high amount to investors to raise seed funding, so the expectations will be rather high. However, if a firm is unable to fulfill the lofty targets, it may have to secure funding at a reduced valuation in the next round.

This could backfire in the long term, and the startup or entrepreneur may have a difficult time persuading other seed financiers or companies to finance them. In contrast, if the business quotes are too low, it may wind up offering investors a larger portion of the company's equity, which will be a negative factor.

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Why High Valued Startups Have the Least Profit?

Startups are not anxious about their losses or lack of profit-making capacity. Instead of focusing on this, they continue to advertise their long-term vision of expected profit generation. Founders of such startups tend to showcase their different techniques, technologies, and solutions to attract investors. They are good at storytelling and selling.

Investors get inspired by the founders and their exclusive pitch and make startup investment risks with the hope of gaining profits in the future. Here, both the startups and the investors work based on future assumptions. The hope remains on the fact that the startup would be able to kill its competition and create its market. But when reality hits and things do not go as per the plans, these startups with high valuations (because of the huge investments) start going low on profit-making.

It is the brand name and its worth that attracts investors to invest, taking the valuation of a startup to another level. For example- Groww (an investing platform), even with the least profits, raised a funding round in October 2021, which skyrocketed its valuation to $3 billion. However, Zerodha (financial services company), one of its biggest competitors, is highly profitable yet its valuation stands lower than Groww.

According to Kunal Shah (CEO of CRED), "Unicorn tag, high valuation are all vanity metrics till the company delivers profits".

The discounted cash flow is the explanation for this unusual valuation. The discounted cash technique is used to value and evaluate the worth of the startups. When valuing a company, the discounted cash flow technique is used to forecast cash flow as well as the anticipated rate of return on investment. Businesses that are inevitably destined to fail in terms of income flow generation are given a higher discount rate.

Such startups simply continue to be overvalued by executing a couple more spectacular funding rounds. After which the investors understand or anticipate that they're not going to be successful after analyzing the stats and other relevant information and pulling any additional funding. These businesses will likely close or downsize their operations, leading to widespread job losses and a repeat of the 2008 financial crisis unless they figure up some sort of magical formula.

Cases of High Valuation Low-Profit Startups

Zomato

The revenue of Zomato has soared by a significant percentage year over year, and losses have also risen by a substantial proportion. However, when you look at the overall picture, Zomato is present in 24 countries, including India. Furthermore, it has a monopoly in Restaurant Search in India, despite the presence of competitors making it more likely to succeed. Advertisements, classifieds, internet shopping, and consulting are further sources of its revenue.

In FY22, Zomato recorded a revenue of $505.76 million, whereas its loss stood at $145.92 million. As a result, instead of seeing losses as a determining factor in funding, we perceive its brand value.

Flipkart

Although this is one of the most difficult startups to evaluate, the basics stay the same. Flipkart is attempting to instill in Indians the habit of shopping online. This is also being funded by investors. Online retail sales in India currently account for only 1% of total retail sales. If it were to rise to even 7-8% (as it is in the United States), E-tailer revenues in India would soar by a significant percentage. This is the expectation of investors.

In FY22, Flipkart India's revenue reached $6.034 billion, and losses widened by 40% to $410.75 million.

Ola/Uber

We usually went down, asked for multiple buses and taxis, and got refused by a majority of them when there was no Ola/Uber. But, thanks to Ola, we can now book a cab from the comfort of our own homes or offices and only get out when they arrive. It has made our lives more convenient with the added benefits of being cashless and air-conditioned. As a result, we have developed a strong trust and habit in them, which is exactly what they desire.

In FY21, Ola Cabs's revenue was $125.41 million, and its loss was $101.27 million.

These are some of the names that stand in full pride with huge valuations as they have gained the trust of investors as well as the masses but at the same time continue to make lesser profits.

Conclusion

A startup's worth is based on its potential to generate future cash flows, how much potential it has for future aspects, and keeping other essential factors constant. Apart from revenue generation, job generation statistics also matter. Investors believe that the startup they are investing in will grow to be a giant one day and that they will be able to make a profit of nearly ten times their initial investment. This risk allows them to stay competitive and keeps them in the play. Therefore, when valuing or comprehending startups, their prospects are perceived rather than the losses.

FAQs

What is startup valuation?

It is the process of evaluating a company's worth in the market based on different factors like profit-making capacity, growth potential, market conditions, etc.

What are startup valuation methods?

Popular methods include:

• Berkus Approach
• Market Multiple Approach
• Risk Factor Summation Approach

Which is the highest-valued company in India in 2022?

Reliance Industries is the highest-valued company in India in 2022 with a $202 billion valuation, followed by Tata Consultancy Services ($139 Bn) and HDFC Bank ($97 Bn).

Are all Indian unicorn startups profitable?

Only 23 out of 100 Indian unicorn startups are profitable. These include Mamaearth, Lenskart, Nykaa, Zerodha, etc.