Why the post-money valuation mannequin is not an correct indicator of value
Below regular circumstances, the upper the valuation of a startup, the higher it’s for all stakeholders concerned. Excessive valuations point out success and the potential of a enterprise; they entice new prospects and new expertise; they construct a repute.
And, offered an organization’s valuation continues to extend, everybody will profit.
As such, founders and traders have all the time been incentivized to imagine in optimistic estimates of an organization’s true value.
Publish-money valuations have been inflated by market expectations in 2021, however they have been additionally inflated by the underlying mechanics of the valuation mannequin itself.
With the intention to navigate the upcoming challenges of a normalizing market, founders want to know the influence of each levers.
The miracle yr of 2021
New traders in a enterprise will all the time look to restrict their danger as a lot as potential.
For founders, staff and VCs alike, 2021 should’ve appeared like a miracle yr. The preliminary warning that gripped hearts initially of the COVID-19 pandemic had light, valuations have been rising and funding was as soon as once more flowing freely.
VC funding quantity almost doubled to $643 billion in 2021, up from $335 billion a yr in the past. Final yr additionally noticed 586 new unicorns in comparison with 167 in 2020 and 1,033 IPOs within the U.S. versus 471 a yr earlier.
Nevertheless, because the transition from 2020 to 2021 confirmed us, issues can change quickly.
In 2022, public tech firms’ share costs and market caps are in sharp decline on account of rising rates of interest, geopolitical developments and normalizing know-how circumstances. In a normalizing market like this one, once-inflated valuations can grow to be a giant downside, significantly for founders, staff and early traders.
Why startups are, by definition, overvalued
To know why inflated valuations are a problem, we have to first have a look at one of many underlying mechanics at work.
In contrast to publicly listed firms, whose valuations are always rising and falling, the valuation of a startup will sometimes solely change after the shut of a brand new funding spherical. The calculation for the startup’s new worth is pretty simple:
New valuation = (share value at newest spherical) x (whole variety of firm shares)
This is called the post-money valuation mannequin and is often accepted because the trade normal.