Startup valuations have become a popular topic in the world of entrepreneurship and investment. They determine the worth of a startup, and this information is vital for investors, employees, and even founders themselves. However, the current methods of determining startup valuations are not perfect, and they can lead to flawed results. In this article, we will discuss the problems with current startup valuations, the impact of inflated valuations, and why there is a need for a new approach. We will also provide examples of startups that have suffered from inflated valuations.
The Problem with Current Startup Valuations
Startup valuations are currently determined based on a variety of factors, including revenue, growth potential, competition, and market trends. However, these methods can be flawed. For example, revenue-based valuations can be inaccurate for early-stage startups that are not generating significant revenue yet. Growth potential-based valuations can also be misleading as projections may not always materialize, and competition can change rapidly. As a result, some startups end up with overvalued or undervalued valuations.
One example of an overvalued startup is WeWork. The coworking company was valued at $47 billion in 2019, but its IPO fell through when investors realized that its business model was not as strong as previously believed. WeWork’s valuation was based on the assumption that it would continue to grow rapidly, but this growth was not sustainable in the long term. As a result, WeWork’s valuation dropped significantly, and the company had to re-evaluate its business strategy.
Another example of an overvalued startup is Theranos, a medical testing company that claimed to have developed a revolutionary blood-testing technology. The company was valued at $9 billion, but it turned out that its technology did not work as promised, and the company was engaging in fraudulent practices. As a result, the company’s valuation dropped to zero, and its founder, Elizabeth Holmes, is currently facing an 11 year sentence.
The Impact of Inflated Valuations
Inflated valuations can have a significant impact on startups and the industry as a whole. For one, they can lead to unrealistic expectations and a lack of focus on long-term growth. When startups are overvalued, they may be tempted to prioritize short-term gains over sustainable growth, which can lead to problems down the line. Inflated valuations can also make it difficult for startups to secure funding in the future if they cannot live up to the expectations set by their initial valuations.
One example of a startup that suffered due to an inflated valuation is Blue Apron. The meal kit delivery company went public in 2017, but its IPO was met with disappointment when its valuation dropped from $2 billion to $1.9 billion. The company’s valuation was based on the assumption that it would continue to grow rapidly, but it faced fierce competition from other meal kit delivery companies and struggled to retain customers. As a result, its valuation dropped even further, and the company had to lay off employees and close facilities.
Startups in Africa and other emerging markets may face unique challenges when it comes to valuation, such as limited access to capital, a less developed ecosystem, and regulatory and political risks. As a result, it is essential to approach startup valuations in these regions with caution and thorough research, taking into account a range of factors beyond just financial metrics.
In order to avoid overvaluing or undervaluing a startup, investors and industry experts should conduct comprehensive due diligence, consider a range of valuation methods, and seek out diverse sources of information. By taking a careful and well-informed approach to startup valuation, investors can help ensure that startups in Africa and other emerging markets receive fair valuations that accurately reflect their potential for growth and success.
Some Unicorn Status African Startups
- Flutterwave: Flutterwave is a Nigerian fintech startup that offers payment processing services to businesses and individuals across Africa. As of March 2021, the company was valued at $1 billion following a $170 million funding round led by Avenir Growth Capital and Tiger Global Management. The company since attaining unicorn status is now valued at more than $3b.
- Jumia: Jumia is an e-commerce platform that operates in several African countries,
- including Nigeria, Egypt, and South Africa. In 2019, the company went public on the New York Stock Exchange, achieving a valuation of $1.1 billion. However, the company’s stock price has since fallen significantly, and its current valuation is unclear.
- Interswitch: Interswitch is a Nigerian fintech company that provides payment processing and other financial services. In 2019, the company achieved a valuation of $1 billion following a $200 million investment from Visa.
- OPay: OPay is a Nigerian fintech startup that offers a range of services, including mobile payments, ride-hailing, and food delivery. In 2019, the company was valued at $1.5 billion following a $50 million funding round led by IDG Capital and Sequoia China.
How startups are valued
Valuing a startup is not an exact science, and there is no one-size-fits-all formula for determining its worth. However, there are several methods that investors and industry experts commonly use to evaluate a startup’s potential value. Here are some of the most widely used methods:
- Discounted Cash Flow (DCF): This method involves estimating a startup’s future cash flows and then discounting them back to their present value using a discount rate that reflects the time value of money and the risk associated with the investment. The formula for DCF is:
NPV = CF1 / (1+r)1 + CF2 / (1+r)2 + … + CFn / (1+r)n
where NPV is the net present value, CF is the expected cash flow, r is the discount rate, and n is the number of years in the projection.
- Market Approach: This method compares the startup to similar companies in the same industry that have already been acquired or have gone public. The valuation is based on the multiples of the valuation metrics of these comparable companies. The formula for market approach is:
Value = Multiple x Revenue or EBITDA
where Value is the estimated value of the startup, Multiple is the valuation metric multiple of comparable companies, and Revenue or EBITDA is the revenue or EBITDA of the startup.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric that represents a company’s profitability by calculating its earnings before certain expenses are deducted.
EBITDA is calculated by adding a company’s earnings before interest and taxes (EBIT) to its depreciation and amortization expenses. EBIT represents a company’s earnings before any interest expenses and taxes are deducted, while depreciation and amortization expenses represent the cost of using and depreciating assets over time. By adding these expenses back to EBIT, EBITDA provides a more accurate picture of a company’s operating performance.
EBITDA is often used by investors, analysts, and lenders to evaluate a company’s financial health and compare it to other companies in the same industry. It is also used in valuation models, such as the market approach, to estimate the value of a company based on its earnings potential.
It is important to note that while EBITDA can be a useful metric for evaluating a company’s financial performance, it does not take into account certain expenses, such as interest payments, taxes, and capital expenditures, that can impact a company’s overall financial health. Therefore, it should be used in conjunction with other financial metrics and considered within the context of a company’s overall financial picture.
- Asset Approach: This method calculates the startup’s value based on its net assets, including tangible and intangible assets such as patents, trademarks, and intellectual property. The formula for asset approach is:
Value = Total Assets – Total Liabilities
where Value is the estimated value of the startup, Total Assets is the total value of the startup’s assets, and Total Liabilities is the total value of the startup’s liabilities.
It is important to note that these methods are not foolproof, and investors and industry experts may use a combination of methods or adjust them to fit the specific circumstances of the startup being valued. Additionally, non-financial metrics such as the startup’s team, market opportunity, and competitive landscape can also play a significant role in its valuation. Therefore, a comprehensive approach that takes into account a range of factors is often necessary for an accurate and reliable valuation.
The Need for a New Approach
Traditional methods of valuing startups have been criticized for their flaws and the negative impact of inflated valuations on the broader economy. Therefore, there is a need for a new approach to startup valuations that takes into account a wider range of factors and provides a more accurate picture of a startup’s potential.
One alternative approach to valuing startups is to use non-financial metrics, such as customer engagement. Customer engagement metrics measure the level of interaction between a company and its customers and include metrics such as customer satisfaction, loyalty, and retention rates. By evaluating a company’s level of customer engagement, investors can gain insight into the company’s potential for growth and future profitability.
Another alternative approach is to consider a startup’s social impact. Social impact metrics measure the positive impact that a company has on society, such as reducing poverty or promoting environmental sustainability. By taking into account a startup’s social impact, investors can evaluate the company’s potential to create positive change in addition to generating financial returns.
These alternative approaches to startup valuation provide a more holistic view of a startup’s potential and can help avoid some of the problems associated with traditional valuation methods. By considering a wider range of factors, investors can make more informed decisions about which startups to invest in and can help support companies that are creating positive change in the world.
One example of a startup that has successfully implemented an alternative valuation method is Patagonia. The outdoor clothing company has a mission to “use business to inspire and implement solutions to the environmental crisis.” As a result, its valuation is not based solely on financial metrics but also on its environmental impact and its commitment to sustainability. This approach has helped the company attract customers who share its values and has allowed it to differentiate itself from competitors.
In conclusion, the current methods of determining startup valuations can be flawed and can lead to inflated valuations that have a significant impact on startups and the industry. Examples such as WeWork, Theranos, Blue Apron, and Patagonia demonstrate the problems with traditional valuation methods and the need for a new approach. As the startup ecosystem continues to evolve, it is essential to re-visit and improve startup valuations to ensure that they accurately reflect a startup’s potential and are not based on unrealistic expectations or short-term gains. A more holistic approach that considers non-financial metrics such as social impact and sustainability can provide a more accurate representation of a startup’s potential and ensure that it is on a path towards long-term growth and success.
This article first appeared in TechBooky Business