Overvaluation of Startups – Decoded

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Since the time we started watching that famous show on startups, “Shark Tank,” we have been going La La over the buzzword “Valuation.” The more valuation one would bring, the more the chances of fetching an equity deal. Look, I do not deny the other important aspects of business, but valuation appears to be the most enticing one on the surface.

So, what exactly is valuation, and why is it so important?

Valuation, in simple terms, refers to the overall worth of a company determined with the help of a few growth parameters. [1]

Business valuation is important, as you would have already guessed.

 What makes it so?

Well, the multi-dimensional deployment of valuation is a predicament for growth in every possible area of a startup.

Sorry for that heavy explanation. Hang on!

The valuation of a startup in and of itself is extremely important. But, how it has become crucial in funding, investment, acquisition, and equity shareholding makes startups anxious over maintaining a sustained valuation. [2]

 Does that explain why companies resort to unhealthy means to increase their valuation?

Kind of, it does. And this explains the sudden surge in the overvaluation of startups.

What is “Overvaluation”?

Overvaluation is a peril. It is a never-ending cycle your startup can potentially get trapped in. A cycle of showing more than what is—expecting more than what you ought to get.

 Sorry for having freaked you out! A bitter truth it is.

 Okay, let us understand the literal meaning and see how unjustifiably wrong it can get.

Overvaluation refers to a stock or asset whose price seems unjustifiably high based on its earning record and other growth metrics. [3]

 

What makes Startups “Overvalue their worth”?

There are several reasons why startups indulge in overvaluation. Some, you may call reasonable. But, most of them – are highly absurd.

 Let us discuss this one by one.

 All eyes are on the large capital

Founders of these startups always wish to keep the cash flow – positive. Of course, who wouldn’t? But, a major part of their valuation anxiety stems from the number of equity shares or shareholders.

 It is obvious for you to ask, “aren’t these equities important for startups”?

Of course, they are, but not at the cost of a founder’s share. And let us agree, no founder gives equity for those embellished words like “mentorship” and “Experience,” as they show on  Shark Tank. Lack of funds or lack of capital is the hard truth.

So, except for a few Bootstrap companies like Apple and Spanx, who were innovative enough to sustain with minimal funding, others need stable funding to generate the required capital for their startup. Most of it, as we see, is in the form of equity.

The more the equity is, the more the founders lose their company share. Now, they found that the best possible way to out compensate the increasing equity is through incrementing cash flow into the venture to keep their share high—this cash flow results in a sudden spike in startup valuation.

It seems like the founder is pushing too hard to take control! But what if the startup doesn’t perform well despite this massive cash flow? 

That is what we plan to discuss next. 

 

Supply Demand Gap

Imagine a venture getting a huge number of investors—a good capital to sustain the business. But, somehow, the team turns lethargic and doesn’t perform well. I know that not performing well would be a downfall of the venture.

But what if I told you that it’s a sudden overvaluation in the short term?

I know, even I was as shocked as you are! But, this is just simple math.

Usually, a company’s output is measured in the ratio of growth and burn. Here, burn refers to the amount of capital invested in marketing, salaries, and other expenses. Now, when the team is not performing well – this means they are actively not pursuing marketing and other growth strategies that require a huge sum of money. 

So, the company’s growth will understandably fall in the long run, but in the short run, all the investor’s money will add to the company’s valuation – resulting in “overvaluation.”

 Can this short-term overvaluation trick more and more investors into the loop?

 It does, But let us look at the “overvaluation trick” performed by both sides.

 

Corporate Investing – Overvaluation pitfall

Let’s be honest. Corporates have their own business goals. So, it is highly likely for them to favor overvaluation if it aligns with their business. You often see these investors assuring you how the accrued benefit will offset the overvaluation. [4]

Now, Hold your horses before you go on to hold only private markets responsible for this. Public Markets are linked with valuation too!

 

Rising Public Markets

 If you have closely followed the stock market, you would have noticed Apple’s and Facebook’s crazy growth during the surge of NASDAQ (the second-largest stock that enables online trading). [5]

These all-time high capital stocks are undoubtedly enticing enough to pull investors into the game, leading to an immediate increase in the share and valuation of firms. 

I understand why overvaluation from all the above-mentioned aspects doesn’t offer any good return in the long run. But doesn’t that only hold true for budding startups?

What explains the overvaluation of startups like unacademy? A predicted 400 crore revenue by FY 2022 is currently pegged at 14000 crores.

 

Why this disparity between huge and small firms

Let us understand that these firms have pedigree founders, high growth, and records exhibiting huge success. Most of the valuation has been organic due to the covid induced popularity of ed-tech firms. [5]

I don’t wish to establish any treatment bias between unicorns and budding startups. But, overvaluation does behave differently with different startups depending on many intricate factors. Not denying that overvaluation many times has been detrimental to the growth of unicorns as well. But, mostly budding startups are at the most risk.

 More often than not, overvaluation for budding startups is dangerous – resulting in a multi-level fallout. Let us get into it and explore the “height of fall.”

 

Overvaluation – The fallout

Now that we have discussed why startups are enticed into this perilous cycle despite an obvious downfall, let us understand the step-by-step route for this fallout.

We will be discussing the growth stages of the company from R1 to R4. Correspondingly there are four valuation values from V1 to V4. To help you get a clear idea, we will break this growth rate into three segments – R1 to R2, R2 TO R3, AND R3 TO R4. Let us discuss the overvaluation puzzle in each of these segments.

 

The beginning

From R1 to R4, we have four normal growth stages without overvaluation. But to lure a bunch of investors, suppose a startup overvalues their growth capital from V1 to V1′ and from V2 to V2′ – corresponding to growth capital R1 and R2.

 Sorry for that gross overcalculation. Hang in there!

 Now that they have overvalued the capital from V1 to V1′, the least you would expect them is to organically match the projected growth rate “V3” from V2′.

 Seems like an easy path while calculating?

It’s even more difficult than convincing an investor to put all his/her money into a startup still in the funding stage. You probably have gotten an idea now.

 Now it’s time we burst this fallout bubble.

The kind of growth we organically expect after the overvaluation of V2′ is rarely possible. One simple reason – The team has not gotten accustomed to breaking their balls in growth areas, including marketing, production, and so on, for sustained organic growth.

Now we know that they have reached this point through an overvaluation. So unless it is an exceptional case, it will be difficult for the startup to proceed to V3 without either overvaluation or devaluation!

 Which path do they choose? Let us discuss this next

Either they can again overvalue the startup if possible, which is outright disastrous as the investors at this stage are also concerned about the market performance.

 Therefore, it is highly likely that the valuation will stay at its previous value – V2′

The scenario is anyday unfavorable. No startup would want their valuation of two rounds to stay at the same point.

 

Now, an ultimate fall is bound to happen!

What did we discuss earlier? Even when the valuation stays the same as V2’, it is still an unfavorable stage but at least leaves the firm more time to recoup.

 But, let us get into the worst-case scenario – I know it is demotivating, but that is what it is!

 What if the valuation in the third round gets even lesser than in the second round.

Reasons?

It can be many, the most probable of all – They tried hard to get growth in valuation but somehow missed the right strategy or maybe went overboard with the spending, and oh crap! It is a loss. This downgrade is the worst of all.

It can potentially prevent any startup from entering the market.

Much like a sailor sailing to get to a nearby bank for cuisine, but with the sudden onset of a dangerous wave, the first thing he will care about is his life.

The same holds for startups – after a certain devaluation, the first thing they care about before any expansion is “Saving the capital or investment first.”

 They can sustain at least not drown, but what about other stakeholders who get adversely affected.

Others who? Let us discuss

 

Overvaluation – The overall impact

According to research, high-growth startups create 50% of the total jobs. Therefore, the most visible impact of overvaluation is evident in the workforce.

 A big example of this has been the overvaluation of ed-tech firms during covid. Post covid, the sudden downfall uprooted more than 400 jobs in each Byju’s and unacademy. You will see them on a hiring spree no sooner than these firms get rapid growth. [6]

They attract a pool of young talents through offers ranging from a whopping salary to paid holidays, to even super Flexi timings. But, what is probably missing from the list of these over-the-top benefits is job security.

As soon as these firms reach a devaluation point, they have no option left but to ask the employees hired on an immediate basis to quit.

Though this is just an immediate effect of devaluation, the more long-term effects are visible on the economy regarding unemployment.

 

What’s the way forward?

We have now got a list of cautionary tales. I hope that serves as enough of a warning to help you stay away from excessive overvaluation. I know the founders have got all their eyes on investment and funding. And that is just – I am not suggesting you all go bootstrap like Apple though.

 But, there are many other ways to sustain a business without getting into a recipe for disaster – Overvaluation. Those can be crowdfunding, soliciting funds from friends or family, or joining a startup incubator. [7]

Solutions are many; you just got to have the vision to sustain without risking yourself and the startup. As discussed, you will only go into a deeper never-ending cycle of overvaluation and devaluation.

As Warren Buffet has rightly said, “You never know who’s swimming until the tide goes out.”

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She is a National level Debater with many accolades and as an aspiring journalist, she aims to present and document content in a well rounded and constructive manner.

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