October 4, 2022

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

Under natural conditionsThe higher the rating of a startup, the better for all stakeholders involved. High ratings indicate success and business potential; attract new clients and new talent; They build a reputation.

Provided that the company’s valuation continues to increase, everyone will benefit.

As such, founders and investors have always been motivated to believe in optimistic estimates of the true value of the company.

Post-money valuations have been inflated by market expectations in 2021, but they are also inflated by the underlying mechanisms of the valuation model itself.

In order to overcome the imminent challenges of the normalization market, founders need to understand the impact of both levers.

2021 miracle

Investors new to a business will always look to reduce their risk as much as possible.

For founders, employees and venture capitalists alike, 2021 must have looked like a miracle year. The initial warning that the hearts that captured hearts at the start of the COVID-19 pandemic had fizzled, ratings had gone up, and funding was once again flowing freely.

The amount of investment capital investment Almost doubled to $643 billion in 2021, up from $335 billion a year ago. Last year also saw 586 new singles compared to 167 in 2020 and 1033 IPO in the US versus 471 a year ago.

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

In 2022, public tech stock prices and market value are experiencing a sharp decline due to rising interest rates, geopolitical developments, and normalization of technology conditions. In a normalizing market like this, inflated valuations can become a huge problem, especially for founders, employees and early adopters.

Why startups are, by definition, overrated

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

Unlike publicly listed companies, which are constantly rising and falling in value, a startup’s valuation usually won’t change until after a new funding round is closed. Calculating the new startup value is straightforward:

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

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

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