Why the post-money valuation model isn’t an proper indicator of worth
Under common instances, the higher the valuation of a startup, the upper it is for all stakeholders involved. High valuations indicate good fortune and the potential for a endeavor; they lure new purchasers and new experience; they assemble a popularity.
And, provided a company’s valuation continues to increase, everyone will benefit.
As such, founders and patrons have at all times been incentivized to consider in positive estimates of a company’s true worth.
Post-money valuations have been inflated through marketplace expectancies in 2021, then again they have been moreover inflated through the underlying mechanics of the valuation model itself.
In order to navigate the approaching demanding situations of a normalizing marketplace, founders need to know the affect of every levers.
The miracle twelve months of 2021
New patrons in a endeavor will at all times glance to limit their threat as so much as attainable.
For founders, personnel and VCs alike, 2021 must’ve seemed like a miracle twelve months. The initial caution that gripped hearts at first of the COVID-19 pandemic had gentle, valuations have been emerging and investment was once once over again flowing freely.
VC investment amount nearly doubled to $643 billion in 2021, up from $335 billion a twelve months previously. Last twelve months moreover spotted 586 new unicorns compared to 167 in 2020 and 1,033 IPOs in the U.S. as opposed to 471 a twelve months previous.
However, for the reason that transition from 2020 to 2021 showed us, problems can exchange briefly.
In 2022, public tech corporations’ percentage prices and marketplace caps are in sharp decline because of emerging interest rates, geopolitical trends and normalizing experience instances. In a normalizing marketplace like this one, once-inflated valuations can develop into a huge problem, particularly for founders, personnel and early patrons.
Why startups are, through definition, overestimated
To understand why inflated valuations are an issue, we need to first take a look at one of the underlying mechanics at paintings.
Unlike publicly indexed corporations, whose valuations are frequently emerging and falling, the valuation of a startup will on occasion only exchange after the close of a brand spanking new investment round. The calculation for the startup’s new value is lovely simple:
New valuation = (percentage value at latest round) x (entire number of company stocks)
This is known as the post-money valuation model and is typically permitted for the reason that industry normal.