Worth Billions But No Profits: Startup Valuation Explained

Almost two new unicorns are born every day, startups with a billion-dollar price tag attached to them. These once extremely rare valuations are becoming, well, less rare. In 2013, billion-dollar businesses only happened four times a year. But in 2021, a staggering 586 unicorns were new to the market. What's the deal with these valuations? Are investors putting their hope into the hype of the next big thing? Or after very public catastrophes like Theranos or FTX, should investors be more wary? Let's look at how to think about the weird phenomenon of value versus valuations in the startup world, and what, if anything, they have to do with each other. If I offered to sell you a dollar bill, I couldn't ask you to pay more than a dollar for it, right? The value of this piece of printed paper is right there, clearly marked. But if I had a rare dollar bill, that piece of paper could be worth, say, $150,000, depending on who's buying. Essentially, this is the difference between value and valuation. The value is the concrete number, what something is actually worth. A valuation is a different thing altogether, basically a forecast of what you think it's worth based on a number of factors. For a company's valuation, it's common to multiply the revenue by a standard rate. This is called a price-to-earnings ratio, which is how much an average investor is willing to spend to earn a dollar from that company. And investors are fickle, so as the economy changes, so does the price-to-earnings ratio for a company. As of now, the P2E is around 21, meaning an investor would spend $21 million to buy a company that earns $1 million a year. Compare that to 2009, when companies were valued at 70 times their revenue, or in the 1980s, when the price-to-earnings was just 8. This tactic for valuation makes some sense for established companies, but what about startups that don't yet have any sales? How do founders with not much more than a business plan and some small test markets get valuations of billions? To do this, investors will often look at comparable companies to determine a fair price, much like real estate does. If you have a startup that makes electric bikes, investors can check the valuation of companies making electric scooters or skateboards to make their valuations. Simple, right? Not always. Take Uber, for example. When investors started to get interested, there wasn't another rideshare company in the market. Instead, Uber had to rely on users to get its valuation, showing investors how many rides people were taking every day. Talking about users is a common way to attract funding to your brand-new platform, even if you're not yet making sales. Now, imagine you run a hotel. You have a fixed number of rooms, and you know roughly how many guests will come each year. It's straightforward to estimate your earnings year after year. But what if you had a hotel with an infinite number of rooms? And what if, instead of a few hundred guests, your infinite hotel had hundreds of millions? And for now, you're letting all these guests stay in your hotel for free, but just imagine how much money you could be making when you figure out a way to charge them. That's the promise companies like Twitter, Uber, or Snapchat make to their investors. They build the hype by promising potential from their users, not actual profits. This is also known as vanity metrics, using terms like users, likes, views, or downloads to talk up a company's valuation. Vanity metrics look good on paper, and they can certainly help to sell investors on high valuations. In 2011, Uber had a valuation of $60 million, all based on operating in just three U.S. cities. But just three years later, it was valued at $41 billion, claiming one million rides taken a day. That meant that Uber gained $30 million in valuation every single day, so when Uber investors heard vanity metric numbers like app downloads or rides per day, they were believers. After all, no investor wants to miss out on the next Uber or Airbnb. So when the next and newest platforms talked about millions of users, investors were reluctant to say no. But these vanity metrics aren't always telling an accurate story. When Snapchat had 83 million users in 2015, it was valued at $1 billion. And even though it now has over 330 million users and is valued at over $16 billion, Snapchat has never once recorded a profitable year. The question is, how much longer are investors willing to wait for companies like Snapchat to finally get a return on their investment? Will vanity metrics continue to attract investors who are happy to wait for future profits? Or maybe investors are starting to lose their patience and demand actual returns. Recently, Meta's shareholders came together to voice serious doubts about the future of the company, saying that Zuckerberg's obsession with his Metaverse is costing the company billions. And Meta's shareholders have a point. While Zuckerberg's Metaverse cost Meta 74% of its value in a year, not a single investor has volunteered more money for the project. FTX, the now-famous cryptocurrency exchange, saw its $15 billion valuation collapse to virtually nothing over a single day after investors stopped believing in the hype of false valuations. And this is not a new trend. In the 2000 dot-com bubble, investors who believed the hype of bloated valuations lost. Big time. In 1998, the grocery delivery service Webvan was vastly overvalued, as were many web-based services at the time. Webvan had just $400,000 in revenue, but went public with a valuation of $4.8 billion. That's a valuation 12,000 times what it was earning. And after three years of losing money, Webvan failed to fool any more investors with its promises and went bankrupt in 2001. More recently, WeWork's investors sobered up and cancelled a very public IPO because its $48 billion valuation didn't line up with the revenue reported. Even Twitter failed to show any real promise, instead relying on Elon Musk's offer to simply buy it out and make it private. And after spending $44 billion and on the hook for $1 billion of interest payments every year, Musk is now frantically trying to do what others could not. Get Twitter to turn a profit. In part because of the very public concerns with Twitter, FTX and the metaverse, investors are calling this a market readjustment, a re-evaluation or a slowdown. Essentially, venture capital firms are sobering up to the reality of finding the next unicorn, especially given the uncertainty with today's economy. Wild market swings and a booming recession make fickle investors jumpy, and companies have to work harder to prove their valuations. Investors need to know they can make their money back, normally through the sale of the startup or through an IPO, but both of these typical cash earners were down an incredible 88% from last year. Even big VC firms like Sequoia Capital are issuing dire predictions, warning their own employees that cash will be tight and spending will decrease. And while investors still want to invest, that means they'll be depending on stronger financials, provable revenues, and a quicker path to profit. In short, investors are still searching for the right opportunity. While it might be cool to say your company's value begins with a B, it's much cooler to have a company that delivers what it promises and sustains growth year after year. We're fascinated by all things business here, including the failures and flops that are making headlines today. After all, seeing the whole picture makes us all more informed and empowered. And no matter what happens in tomorrow's news, we'll be there to break it down. Remember that if you watched more than one video from Startup Savant, this is your cue to subscribe for access to the next video. Comment what you'd like to see from us and we'll consider it. We read every single comment.