Why the post-money valuation mannequin is not an correct indicator of price
Beneath 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 appeal to new prospects and new expertise; they construct a status.
And, supplied an organization’s valuation continues to extend, everybody will profit.
As such, founders and buyers have at all times been incentivized to consider in optimistic estimates of an organization’s true price.
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.
As a way to navigate the upcoming challenges of a normalizing market, founders want to grasp the impression of each levers.
The miracle 12 months of 2021
New buyers in a enterprise will at all times look to restrict their danger as a lot as doable.
For founders, workers and VCs alike, 2021 should’ve appeared like a miracle 12 months. 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 nearly doubled to $643 billion in 2021, up from $335 billion a 12 months in the past. Final 12 months additionally noticed 586 new unicorns in comparison with 167 in 2020 and 1,033 IPOs in the U.S. versus 471 a 12 months earlier.
Nonetheless, because the transition from 2020 to 2021 confirmed us, issues can change quickly.
In 2022, public tech corporations’ share costs and market caps are in sharp decline as a result of rising rates of interest, geopolitical developments and normalizing know-how situations. In a normalizing market like this one, once-inflated valuations can change into a giant drawback, notably for founders, workers and early buyers.
Why startups are, by definition, overvalued
To grasp why inflated valuations are a problem, we have to first take a look at one of many underlying mechanics at work.
In contrast to publicly listed corporations, whose valuations are continuously 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 worth at newest spherical) x (complete variety of firm shares)
This is named the post-money valuation mannequin and is often accepted because the trade customary.