Are Startups Across The World Moving Into Bubble Valuations ?

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It is hard not to be baffled by the breath – taking investments happening in startups across the world. The amount of money raised by startups, that are barely a few years old, is surpassing even the revenues of most of the traditional industries.

In the year 2000, a similar bubble was being built up. Anyone owning a website with a “.com” suffix could just approach an investor and get a check written for, sometimes, millions of dollars, whether one had a business plan or not. The insane valuation commanded by these companies led to an unprecedented rise of the stock market.

Sadly the days of good times were not for long. In the year 2002, the stock market crashed badly leading to huge losses and closing of business ventures. The insane valuations that were commanded by these companies were reduced to nothing in short time.

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So how a bubble starts?

One of the most probable reason, a bubble builds up is that a buzz is created in the market, that either a new business category or a new way of doing business is going to reap rich rewards to investors, who invest early. The proponents of this paradigm often overplay the impact of this scenario. If the buzz catches on, a lot of new investors jump on the bandwagon, and soon the valuations start building up.

In the year 2000, the mantra was “get bigger or get out”. Investor assumed that the only way to achieve the rapid growth was to acquire as many customers as possible by burning huge cash. When this was done, these companies could just list on a stock market through an IPO and investors would happily cash out with big dollars.

The speculation around the new age companies prompted investors to put cash in any company they could lay hands on. The spectacular rise of the stock market because of the built in speculation lead to these companies demanding extreme valuation.

At one point in time, a relatively new entrant, Amazon was trading at $107.

What caused the dot-com crash?

An economic crash happens when the sentiments opposite to the boom time gain traction. When earnings reports start coming in, it triggers a panic sale.

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When investors realized that companies they had invested in, could not bring in a fraction of revenue on which valuations were based, they started selling. The panic selling started the end of the dot-com era.

It was very clear that the primary reason for the crash was a lack of revenue combined with the inability to generate cash flow. Cash flow is the amount of money with the company after all cash in a bank, hand and inflows are added, and the outflows are subtracted. If a company does not have cash, it goes bankrupt. Beyond a point, investors were not willing to fund the companies in the absence of any revenue sighting.

Having learned about the dot-com crash, can we conclude that the similar kind of bubble is being built in the startup sector these days?

A few examples which indicate that such a bubble already exists are huge valuations commanded by Uber ($42 billion+), Twitter, Alibaba ($168 billion) and many others. The amount of valuation commanded by these companies still needs to match up the revenues that they are bringing in or will bring in the future.

For example, Uber with a revenue of just $1.2 billion was once valued at $18 billion+ which is about 16 times of its earning. If due to any reason, Uber comes under any problem (which it already has across the world) because of government regulation, opposition from taxi industry or any other reason, it will not be able to provide the kind of revenue investors are expecting. The cash flow would not be enough to sustain the company and also generate future investment leading back to the crash situation of 2002.

And, to make the scenario more worrisome, some of the industry thought leaders feel that it would take another 9 months to 12 months before we find ourselves into an another – and much bigger – bubble burst.

How about Indian market?

The Indian retail industry, during the time of retail boom, was priced at a size of $200 billion. At current times, most big Indian retailers are bleeding, unable to reach anywhere near the expected market size.

The startup boom has come to the shores of India too, as a number of companies, without much earnings to show, are able to raise millions of dollars. Top companies like Flipkart, SnapDeal, Jabong, PayTM and others are commanding billion-plus valuations.

Flipkart’s revenue for example in 2013 – 14, was $1 billion and the losses were $46.83 million (Rs. 281 crores).

Flipkart now commands a valuation of over $11 billion now. Looking at the loss figure the whole scenario smells of an investment bubble. Every new day one hears of more and more companies hitting the billion dollar valuations.

OlaCabs, which has recently secured a fresh funding round of $315 million, is exploring new avenues to generate positive revenue. To compete with Uber, the Indian counterpart has to leave enough of money in their customers pocket and provide services at a loss in the name of customer acquisition. But how many customers will stay loyal to the service once the honeymoon period is over and OlaCabs starts charging with adequate profit margin?

The current investment pattern starts with seed funding. The seed funders then sell out their stake to angel investors who in turn scout for Venture Capitalists. The final culmination of these exits happens at the stock market. However, for a startup, it is not easy to list itself on Indian stock market as listing requirements for Indian stock exchanges is pretty stringent – a company needs to have the minimum share capital and be profitable for at least three years. So who will be the final one to hold the dead pigeons is still to be seen! Yes, you may argue that NYSE and NASDAQ are meant for such Indian startups but will that help the public investors make profit?

Let us do a check-list of current startup bubble

  • Do valuations justify current earnings – NO
  • Is there a mad rush to fund the startups which do not have adequate cash flow development strategies –YES
  • Is the business model about acquisition of users rather than revenue or profitsYES

Warren Buffet once said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

We can only hope; investors are applying their mind well before investing today.

We know few of you, especially those funded startups and budding entrepreneurs, may not be agreeing with the fact, though, we would like to ask from our readers – who also happens to be the industry’s thought leaders – how do you see the current startup scenario. Cast your vote.

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