Funding Startups

Amol Dani Apr 26, 2016

There was a time when it was widely believed that “You are worth nothing until you’re profitable”; today this assumption seems flawed. For good, or for bad, media today is abuzz of stories of startups claiming phenomenal valuations and preposterous investments. If media reports are to believed, Flipkart has $2.45 billion, SnapDeal has $1 billion, PayTM has $610 million, Ola has $276.9 million and Quikr has $196 million in investments. What’s actually baffling to many is the fact is that these startups are far from being profitable; their losses are way too much. Obviously one can’t help but wonder as to why do these loss making enterprising are receiving such significant investments?

As a thumb rule, valuation is the fundamental basis upon which investors determine the amount of stake in the company which entrepreneurs would have to give them in exchange for seed money. If an entrepreneur is looking for a seed investment for around $100,000 in exchange for about 10% of his company; his pre-money valuation of his stocks should be $1 million. This however does not mean that his company is worth $1 million now. Valuation at the early stage is more about growth potential as opposed to present value.

When Drew Housten went to venture capitalist – Y-Combinator – they paid a seed capital of $20,000 in exchange for 5% of Dropbox; valuation of startup was $400,000. When Kevin Storm was paid by Baseline Ventures $ 500,000 in exchange for about 20% of Instagram; initial valuation of his company was $25 million. Today both these companies are valued over $1 billion.

In new age startups the key to success is all about bringing in the right idea to life by getting right people to work for you. Since startups are low in cash the obvious way to lure employees is by offering them a stake in the company in addition to a nominal salary. These stocks which are set aside for offering to future employees are called Option Pool (OP). Normally OP is around 10-20%. What is also interesting to know is that larger the OP – lower the valuation of a startup. Why? That’s because OP is valuation of future employees which startups don’t have when they are beginning.

The following factors play a pivotal role in evaluating startups, namely: Market forces, the regency and size of exits in similar startups, willingness of an investor to pay a premium and, also, level of desperation in entrepreneur for want of money

The question many entrepreneurs ask is “How do I get huge valuation?” The right question is to ask “Do I need a high valuation?” And the answer is most definitely – “not really!”. This is so because when you get a high valuation for a seed round, for the next round you’d need even higher evaluation. This means that you’d need to grow phenomenally between two rounds. Generally it’s anywhere between a year and two. Should you fail to register 10 times of growth you’d lose all interest from investor’s side – probably for good. There are two strategies often chosen by entrepreneurs:

Thrive or Die: This is about raising as much sum possible by getting a high valuation before spending all the money to attain exponential growth in terms of market capitalisation. Should this gamble pay off – your next valuation is higher; so high that your seed round pays for itself. The assumption here is that if a slower-growing startup experiences 55% dilution, the faster growing startup will only be diluted 30%. So you save yourself 25% that you spend in the seed round. This is the strategy that is being adopted by the likes of Flipkart, SnapDeal etc. So far their gamble seems to be paying well; yet their accumulated losses – to this day – is way too high. None of the business analysts seem to be speaking about it.
Get as you Go: Here startups raise only that much amount as much they need. Spend as little as possible and aim for a steady growth rate. There’s nothing wrong with steady growing startups. It’s just that your evaluation grow steadily. This might not get you in the news but you will raise your next round. This is the more sensible yet not sought after since startups are deprived of media glare.

Of all the things it’s crucial for an entrepreneur to understand that investor’s perspective is always the ultimate key. What an investor understands and assumes will finally determine fate of your startup. So ensure that you’ve got earned the trust of your investor and know for sure that – an investor can’t be fooled twice.