Bastian Hasslinger
Under normal circumstances, the higher the valuation of a startup, the better it is for all stakeholders involved. High valuations indicate success and the potential of a business; they attract new customers and new talent; they build a reputation.
And, provided a company’s valuation continues to increase, everyone will benefit.
As such, founders and investors have always been incentivized to believe in optimistic estimates of a company’s true worth.
Post-money valuations were inflated by market expectations in 2021, but they were also inflated by the underlying mechanics of the valuation model itself.
In order to navigate the impending challenges of a normalizing market, founders need to understand the impact of both levers.
The miracle year of 2021
For founders, employees and VCs alike, 2021 must’ve seemed like a miracle year. The initial caution that gripped hearts at the beginning of the COVID-19 pandemic had faded, valuations were rising and funding was once again flowing freely.
VC investment volume nearly doubled to $643 billion in 2021, up from $335 billion a year ago. Last year also saw 586 new unicorns compared to 167 in 2020 and 1,033 IPOs in the U.S. versus 471 a year earlier.
However, as the transition from 2020 to 2021 showed us, things can change rapidly.
In 2022, public tech companies’ share prices and market caps are in sharp decline due to rising interest rates, geopolitical developments and normalizing technology conditions. In a normalizing market like this one, once-inflated valuations can become a big problem, particularly for founders, employees and early investors.
Why startups are, by definition, overvalued
To understand why inflated valuations are an issue, we need to first look at one of the underlying mechanics at work.
Unlike publicly listed companies, whose valuations are constantly rising and falling, the valuation of a startup will typically only change after the close of a new funding round. The calculation for the startup’s new value is fairly straightforward:
New valuation = (share price at latest round) x (total number of company shares)
This is known as the post-money valuation model and is commonly accepted as the industry standard.
Let’s demonstrate how it works with an example: If a VC were to invest €10 million in a business for 1 million shares (a price of €10/share) and the total number of shares in the company at the end of the round was 10 million, the post-money valuation of the startup would be €100 million (€10/share x 10 million shares).
This approach might seem like the most logical way to value a business, but the model often implicitly overstates the true value of the company, even if the share price paid by the investor is fair. The reason for this is that not all shares are equal.
New investors in a business will always look to limit their risk as much as possible — if things start to go downhill, they want to be able to recover as much of their investment as they can. So, new investors will try to negotiate better conditions for themselves and will pay a premium in exchange.
How a floundering SpaceX grew in valuation
A great example of this is SpaceX. After the company closed a Series D round in 2008, its post-money valuation was 36% higher than the previous round despite the economic downturn caused by the financial crisis and several failed rocket launches. Why?
SpaceX’s Series D shares were issued with certain protections. In the event of liquidation, Series D investors were guaranteed to get a 2x return on their investment before any other shareholder would receive any remuneration.
This new share class was, by design, much more valuable than any other in the company — and thanks to the downside protection, investors were willing to pay a higher price.
But when the post-money valuation model was applied to SpaceX, all the shares were treated as if they were worth the same (they weren’t), and the company was overvalued accordingly.
Why founders, employees and early investors have the most to lose
Despite its obvious failure to take the differences between share classes into account, post-money valuation is usually an effective and sufficient method for calculating a startup’s valuation.
In a healthy market, a company’s valuation is likely to grow again with the next funding round or an exit, so the inflated value is of little concern.
It remains fair, too. Provided that a company exits at a higher valuation, every shareholder will receive a payout equal to the proportion of the company they hold — if you hold 5% of a company that’s sold for €100 million, you get €5 million).
In the case of SpaceX, the company being implicitly overvalued at that point was never an issue. However, had it been sold at a lower price than its post-money valuation, some shareholders — most likely founders, employees and early investors — would have found their stake to be worth much less than the valuation implied.
The harsh reality of 2022
Today, we find ourselves in a normalizing market where below-valuation exits and down rounds will be an unfortunate reality for many founders, employees and investors who benefited from the inflated valuations of last year. For them, 2021 will cease to look like a miracle year and will instead appear to have been a curse.
Some of tech’s biggest names have reason to be concerned. In less than a year, Klarna’s valuation has dropped from $45 billion in October 2021 to $30 billion in June 2022); Canva’s value dipped from $40 billion to $27 billion, and Gopuff’s market cap has declined from $17 billion to $8.3 billion.
The companies forced to exit or go public at a lower valuation than their worth last year will share the misfortune of companies like Shazam and Blue Apron. Premium share classes will be protected, and every other share class will receive much less. Companies facing bankruptcy will be in a similar situation.
And startups that can persist at lower valuations will inevitably see their reputations suffer, as well as their ability to attract and retain talent. Generous employee share options will become much less appealing when their value is halved and question marks loom over their potential to return anything at all.
What can we learn from the current situation?
While we’d all love to have a few simple hacks to boost the value of our companies or halt a normalizing market, such things are only possible in the realm of fantasy.
The situation today is a harsh reminder for founders and a timely lesson for new startups at the beginning of their journey.
If you are to take anything away from the demoralizing market decline of the past six months, let it be this:
Remember that any valuation is hypothetical
The post-money valuation of a startup is a strongly simplified approximation of its actual value, especially in the early stages when a company doesn’t have strong revenue or an advanced product. It is only an “imaginary” metric — a belief in the future. A valuation remains nothing but a number on a piece of paper until it is realized via an exit.
Assume your business is worth less than what it was before
Due to significant changes in startup capital markets, your past valuation might not be rational today. With many emerging public tech companies trading down about 50%, there’s little reason to believe that your company will be worth the same as it once was. Be aware of the changes in the market and act conservatively.
Understand the value of the stake you hold
Every share class is different, and so is its value. Be aware of the class of the shares you hold and the impact that other contractual terms have on their value. Metrick and Yasuda (Yale & UC), and Gornall and Strebulaev (Stanford), have proposed frameworks for understanding the terms that influence cash-flow rights for investors upon exit. This will allow you to estimate the value of each share class and will provide you with a more accurate valuation of your company.
Be cautious about accepting overly protective share terms
When negotiating future rounds, be aware of the trade-offs. It might initially seem like a good idea to accept punchy contractual terms to maintain your “inflated” valuation, but you should exercise caution. Such terms always lead to a misaligned shareholding structure that leaves common shareholders (you and your employees) at the bottom of the pile.
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