Startup Devaluation, The Potential Danger for Investors.
In the previous posts, we discussed the concept of valuation, the reasons for the high valuation of tech startups, different methods of valuing startups, as well as the disadvantages of overvaluation of startups. In this article, we intend first to address the reasons or motives and then the drawbacks of startup devaluation.
The Problems of a Lower Valuation
Contrary to the misconception of some venture capitalists that equate startups devaluation with success in stock trading, startups’ devaluation is not beneficial to either party.
However, from the founder’s point of view, underestimation is not useful either. Because the founders, as sellers and considering the philosophy of Economic Rationality, are not interested in selling their shares cheaply.
Stay tuned with SOJECT; we will address the problems of startup devaluation.
Reasons for Low Valuation of Startups
Imbalance of Supply and Demand in Startups Ecosystems
When the number of venture capitalists is limited, and in contrast, the number of startup teams seeking capital is enormous, startup founders eventually have to accept the startup’s undervaluation to access the limited financial resources available in this ecosystem.
In fact, in the absence of numerous venture capitalists in an ecosystem, the bargaining power of capitalists will increase.
Lack of Sufficient Financial Knowledge in the Founders
If startup founders do not know how to value the startups, they may fall into the trap of investor devaluation.
In some valuation methods, the parameters influencing the value of a startup are numerous. Consequently, if the founder is unfamiliar with these issues, the venture capitalist will manipulate these parameters to convince the founders that the startup has a lower value than he expects.
The Traditional View of Investors
Traditional investors, who have not previously experienced investing in startups, often have difficulty accepting startup valuations.
Traditional investors often do not have a sufficient understanding of the exponential power and value of the team, intangible assets and the product. They treat startups similarly to traditional, asset-based businesses and often devalue startups.
Disadvantages of Startups Devaluation
Insufficient Capital Injection and Lack of Startup Growth
Investors’ goal of underestimating is to get more shares in exchange for injecting the same capital. On the other hand, raising startup capital through another investor may not be justified for startup founders. Due to a low valuation, they have to transfer more shares to the investor to attract the same amount of money. Therefore, the startup may be satisfied to raise part of its initial capital needs.
Raising capital more diminutive than the required amount is dangerous as it causes a lack of budget. A low budget prevents the scale and implementation of startup growth and development programs.
Since the nature of a startup is growth and scalability, by injecting less capital than required, the venture capitalist has practically prevented the startup from growing and scaling. Obviously, this will be detrimental to both parties.
Reducing the Startup Founders Motivation.
Devaluation causes founders and employees to lose their motivation because they have to transfer more shares in exchange for their required capital.
On the other hand, devaluation will dilute the founders’ shares during the following rounds of raising capital. So, finally, they may not have a reasonable percentage of stock left that will motivate them to stay.
Increase the Risk of Startup Failure
Underestimation can also be risky for a venture capitalist. Because in the next rounds of raising capital, new investors, realizing the devaluation in the previous round and considering the low stakes of the founders, may avoid investing. Naturally, the risk of startup failure in the early stages increases if the team cannot raise capital.