Gauging the potential success of a startup can be tricky for any investor. But at the end of the day, a company’s fundamentals remain a reliable guide.
Equity usually brings returns in mainly two ways: profit (dividends) and capital gains. In a textbook scenario, the two are interrelated. More profits per share increase its price based on a multiple that reflects the potential investors place on it. With profit, pricing equity is reasonably attainable; more so in the case of listed businesses in free markets.
But few if any textbooks will give you a clear formula to price equity in a losing company. Mathematically, pricing a company with negative profit yields zero, and that’s being generous. So how do you value a startup with natural losses? The answer is still the company potential, but this time linked to a whole lot of risk.
An angel or a VC usually buys equity in a startup because they either see potential to succeed or find the equity price adequately discounted for risk. But that pricing is still elusive. And as long as investors focus primarily on comparative benchmarking (i.e. looking at what other similar companies were valued at) there will always be pitfalls.
Revenue is a trap. Sure, we can all agree revenue is the first indicator that a company has a sellable product. Increasing revenue shows a growing customer base. But the trap lies in believing the potential story while revenue is unsustainable. Anyone can start a business selling a product at a loss and still show revenue. That doesn’t mean it has potential (or valuation). Investors shouldn’t simply jump in on the revenue growth story. If they don’t ensure that the revenue model has decent margins and will turn profit at an achievable scale, they might as well be handing out money to customers directly.
An equally important question to ask when pricing is what’s the end game? How does the investor make returns? Some will say IPO, but good luck listing a tech company with any of the typical fundamentals expected by market investors. Most tech listings have been punished post-IPO at one point, proving too much potential was bet in the beginning.
Others might say a buyout is another exit model. Maybe, as long as we’re giving clear thought and planning to who can buy and at what price before it’s too expensive. Many in the region (some of the biggest) counted on a buy-out by Amazon. Guess what? They’re still looking and their recent rounds are looking more like bailouts rather than investments.
Most importantly, out of many thousands of startups, very few have lived the Facebook and Google experience apart from, well, Facebook and Google. The same rarity applies on the investor side. Not everyone is Peter Thiel. Many of us are looking in the wrong places and putting money in the wrong businesses for the wrong reasons. The industry might have changed tremendously. The potential is much bigger, but the fundamentals are still the same. Even the unicorns will tell you that.