Mon. Aug 8th, 2022

Why the post-money valuation model is not an accurate value indicator?

under normal circumstances, the higher the valuation of a startup, the better it is for all stakeholders involved. High ratings indicate a company’s success and potential; they attract new customers and new talent; they build a reputation.

And if a company’s valuation continues to rise, everyone benefits.

As such, founders and investors have always been encouraged to believe in optimistic estimates of a company’s true value.

Post-money valuations were boosted in 2021 by market expectations, but they were also boosted by the underlying mechanisms of the valuation model itself.

To face the looming challenges of a normalizing market, founders need to understand the impact of both levers.

The miracle year 2021

New investors in a company will always try to minimize their risk as much as possible.

2021 must have seemed like a miracle year for founders, employees and VCs. The initial caution that gripped hearts at the start of the COVID-19 pandemic had faded, valuations rose and funding was pouring in freely.

Venture capital investment volume nearly doubled to $643 billion in 2021, up from $335 billion a year ago. Last year there were also 586 new unicorns compared to 167 in 2020 and 1,033 IPOs in the US versus 471 a year earlier.

But as the transition from 2020 to 2021 has shown us, things can change quickly.

In 2022, stock prices and market capitalizations of public technology companies will fall sharply due to rising interest rates, geopolitical developments and normalizing technology conditions. In a normalizing market like this, once high valuations can become a major problem, especially for founders, employees and early investors.

Why startups are by definition overvalued

To understand why inflated valuations are a problem, we first need to look at one of the underlying mechanisms at work.

Unlike publicly traded companies, whose valuations are constantly rising and falling, a startup’s valuation usually only changes after the close of a new financing round. The calculation for the new value of the startup is quite simple:

New valuation = (share price latest round) x (total number of company shares)

This is known as the post-money valuation model and is widely accepted as the industry standard.

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