Startup Valuation is a beautiful bubble. The burst isn’t usually pretty.
By Chinyere Okafor
Most entrepreneurs or startup founders think that valuation is what their company is worth. This ties nicely into how much of the company they believe they will be giving up to investors. This is not how it works. Valuation is a reflection of a set of expectations of how the company will do in the future based on its current state and trajectory.
While it is easy to get a $1m or even $2m post-money valuation on just a business plan at an angel round, the expectation is that when next the founder needs to raise money, the business model must have been proven, a minimum viable (preferably loveable) product developed, and a customer base acquired.
This is ideal, but if wishes were horses, the whole town would be stinking from horse excreta. Startups, fresh out of the oven, with minimal traction want a $10m valuation. We have repeatedly seen startups anchoring their valuation on-air; completely devoid of reality. Powered by their perfected pitch decks, fancy graphics, and brimming with the latest buzzwords, they try to justify the unjustifiable.
As a VC, engaging and sometimes arguing with startups about their valuation is usually a tiring game of mental jiu-jitsu; a dangerous roller coaster at the best. Many of these startups have such overinflated valuations based off of spurious claims and fictional numbers. They use all the arguments in the world to support themselves. One very popular one is that customer acquisition and building traction is the best go-to strategy for success. This thinking of growth and traction being the key parameter to success over, and above actual revenues and profits is the hill they are willing to die on. Their thinking goes to the fact that once the users are in place, business and revenue models can and will be worked out. Like if you have the eyeballs, you can make money off them.
The fallacy in this is glaring but just not to them. If there is little or no revenue and profit, then there are no cash reserves. If they run out of money what next? I hypothesize that they believe that once they run out of money, there will be another investor somewhere to further fund their venture (next round). These category of startups are no longer building sustainable companies, solving real problems and adding value. They have perfected venture financing as another well finessed business model and can be said to be busy fundraising, growing their valuation and rearing a unicorn. Who doesn’t want to be in the “unicorn” club?
We have already begun to see that when these overvalued companies launch their IPOs, there is almost always a huge devaluation in the public market, which frequently prices these companies at a lower value than original investors. Trivago, a popular German hotel search engine saw a huge 29% one-week price decline post-IPO, simply because the market dramatically disagreed with its valuation. The recent come down of WeWork from the stratospheric $47bn to $9bn in 2 months, pre-IPO but after they have released their S1 filing, (this is a public document used to register proposed IPO with the SEC) is yet another example. If the value was there, could they have disappeared that fast? Let us not forget Jumia which is closer to home. Jumia was valued at $3.14bn on April 17, 2019, when it was listed on the New York Stock Exchange, 5 months later, it is now valued at $523.78m.
The VC world needs to take a step (more of a couple of steps) back to reassess what should drive valuation. More realistic and traditional valuation and performance metric should be re-adopted, while the unconventional ones jettisoned. Answers to questions like — when did the company raise its last round of funding, is the company successfully generating revenue, what is the company’s growth — could be very instructive to the VCs decision making.
I do not want to be a messenger of doom but if this trend of overinflated valuations of startups persists with all the attendant effects and consequences, the implosion ahead will be very severe. While the fatalities might (or not) be limited, what will be lost, money, job etc will be astronomical.
