Startup Overvaluation, The Potential Danger for Founders.

Startup overvaluation

In the previous article, we discussed the disadvantages of startup devaluation for venture capitalists. However, the interesting point here is that just as devaluation is risky for the investor, overvaluation is also detrimental to the founders. It may seem a little strange at first; But in the continuation of this article, we bring the reasons to light.

Disadvantages of Startup Overvaluation for Founders

Contrary to the founders’ initial assumption that overestimating a startup value equates to success in fundraising negotiations, it is not beneficial to any of the parties (founders and venture capitalists).

However, sometimes overvaluation occurs. In the following, we have examined the disadvantages.

Overvaluation

The most important risk faced by the founders and previous round investors due to startup overvaluation is the falling of value in the following rounds, leading to the difficulty of attracting capital.

The Risk of Down round

To better understand this concept, pay attention to the chart below.

The hypothetical startup in Figure 1 (green) grows logically in four stages of capital increase (R1 to R4) with no overvaluation. In fact, the green chart shows the logical, expected and real growth trend of the startup value.

Now, if we assume that the same startup has been overestimated in the early stages, there are three possible scenarios beyond. (Note that the actual and fair valuation of this hypothetical startup in the final stage of a specific numerical capital increase will be equivalent to V4.)

The First Scenario of Overvaluation (Red Graph)

The hypothetical startup is overvalued in the first and second stages, and for the following rounds, it is forced to experience less value growth than the green chart to reach the value of V4 in the last stage (stage 4).

In this scenario, the startup must experience very high growth. In the first and second stages of raising capital (R1 and R2), the fair value of this startup was V1 and V2, respectively, but due to the overvaluation, the value has been changed to V ‘1 and V’2.

To reach the final value of V4, the startup must match the value of V ‘3 in the third round of investment (R’3), which has a higher value than V3. Therefore, this startup must show high growth from the second stage (R2) onwards to go through the scenario similar to the red chart. Obviously, this growth requires a lot of effort and energy from the startup team.

In fact, in the red chart, due to the overvaluation in stages 1 and 2, the startup’s value has increased more rapidly than the startup growth indicators, and to compensate for this gap, the startup in the following steps must redouble its efforts to prevent Down round.

While difficult for the startup, this scenario is the best in comparison to the following two scenarios (purple and grey charts).

The Second Scenario of Overvaluation (Purple Chart): The Unchanged Startup Valuation in the Second and Third Round

In this case, when the startup is overvalued in the first and second stages, in stage 3 (R’3), it returns to the value of its previous step (V’2). If the founders attract capital with the same value at this stage, the startup will correctly continue its growth. (Corresponds to the green chart)

However, no startup wants to have its valuation fixed in two consecutive rounds.

This scenario is unfavourable compared to the first scenario (red diagram). However it has fewer consequences than the following one (grey diagram).

The Third Scenario of Overvaluation (Grey Chart): Startup Valuation Decline in the Third Round.

In this scenario, the startup’s value in the third round is less than the second one. It usually occurs due to overvaluation or poor startup performance in the previous rounds of raising capital.

In fact, in the third scenario, the overvalued startup has to experience a downgrade to keep pace with real growth (green chart). Falling stock values ​​are the worst thing a startup can experience. Investors in the previous stages do not make returns and also suffer losses in the value of their stocks. This issue alone can prevent venture capitalists from entering the next round.

Startup Overspending

In addition to the devaluation of startup stocks and the difficulty of raising capital in later stages, other disadvantages of overvaluation include startup overspending. Many overvalued startups start to overspend after transferring a small percentage of shares and receiving a large amount of capital.

These overspendings include exorbitant and inefficient marketing costs, expensive and luxurious office, high staff salaries, and so on. Expenditures that waste time, capital and startup growth potential!

Overspending

Reasons for Startup Overvaluation

The Startup Need to Attract a Large amount of Capital.

Because of their innovative nature, startups usually need a lot of capital to market their product and gain market share. This need continues until the Startup’s net cash flow gets positive.

On the other hand, with the increase in the number of investment rounds, more and more shares gradually fall out of the founders’ ownership and become the property of the investors. Under such circumstances, the founders instinctively tend to control the number of transferred shares.

The number of shares transferred to the investor directly relates to the amount of injected capital. However, it is inversely associated with the startup’s valuation.

On the other hand, to achieve the startup growth goals, the founders can not reduce the capital required. So they inevitably try to divert fewer stakes to venture capitalists by overvaluation. This causes startups to raise their valuations to attract more capital in exchange for fewer shares!

Rising Public Markets

Valuation methods depend somehow on the state of public markets (stock market). This is because some of the parameters required to value startups are derived from public market data and trends. It is evident that the significant increase in stock prices in public markets affects the valuation of startups. This increase paves the way for overvaluation.

Consider, for example, the beginning of 2016 – when the NASDAQ index reached its highest level in history. Shares of companies such as Apple, Alphabet, Facebook and Amazon experienced significant growth. At the same time, Snapchat shares were scheduled to go public in early 2017. The conditions of the US stock market at that time looked promising. As a result, the startups like Snapchat looked more attractive than before. This condition provided the basis for overestimating many startups.

Unequal Competition and Imbalance of Supply and Demand

In a startup ecosystem, the number of investors and startups significantly impacts balancing the ecosystem. If the number of investors and the amount of capital at their disposal is high compared to the number of solid and appropriate teams and ideas, we will face overvaluation and vice versa!

In such a situation, investors will enter the competition to hunt for suitable startups that are few. This competition will lead to overvaluation.

Corporate Venture Capital Investing

These companies generally overestimate the startup in order to make a strategic investment in line with their business goals as well as buying shares in a successful startup. Using this strategy, they increase the chances of investing or buying a startup.

Such companies generally enter the game by arguing that the benefit created by investing in a startup or acquiring it will offset the overstatement in the future. We should note that any corporate venture capital investment does not necessarily lead to overvaluation.

Startups Overvaluation, a Common and Global Problem

Recently, one of the most interesting topics is the overvaluation of startups worth more than $ 1 billion, or so-called unicorns. Between 2013 and 2017, the number of US Unicorns increased from 40 startups to more than 120.  Their total value by the end of 2017 is estimated at more than $ 600 billion. According to a 2016 survey of 681 venture capital funds, 91% of these funds believed that unicorns were overvalued.

Will Gornall and Ilya A. Strebulaev of the Universities of British Columbia and Stanford modelled a method for valuing unicorns. The revaluation of 116 American unicorns based on this model showed that, on average, about 51% of the unicorns studied had an overestimation problem in previous valuations. One of this research highlights is the observation of 13 unicorns with more than 100% overvaluation.

Unicorns

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