Most startups had been overvalued earlier than 2021, and now it’s inflicting issues

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 entice new clients and new expertise; they construct a popularity.

And, offered an organization’s valuation continues to extend, everybody will profit.

As such, founders and traders have at all times been incentivized to consider in optimistic estimates of an organization’s true price.

Publish-money valuations had been inflated by market expectations in 2021, however they had been additionally inflated by the underlying mechanics of the valuation mannequin itself.

With a view to navigate the upcoming challenges of a normalizing market, founders want to know the impression of each levers.

The miracle yr of 2021

New traders in a enterprise will at all times look to restrict their danger as a lot as attainable.

For founders, workers and VCs alike, 2021 should’ve appeared like a miracle yr. The preliminary warning that gripped hearts in the beginning of the COVID-19 pandemic had pale, valuations had 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 yr in the past. Final yr additionally noticed 586 new unicorns in comparison with 167 in 2020 and 1,033 IPOs in 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 corporations’ 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 change into a giant downside, notably for founders, workers and early traders.

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 continually 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 easy:

New valuation = (share worth at newest spherical) x (whole variety of firm shares)

This is named the post-money valuation mannequin and is usually accepted because the trade normal.

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