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
New investors in a business will always look to limit their risk as much as possible.
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.