As a startup founder, it is natural that one wants to up their game in terms of the valuations, and while it can be pretty tough to derive the worth of a startup, the real challenge, though, is avoiding a valuation that is too high.
There is something called the Goldilocks Principle which basically points to the middle ground or the ideal.
The concept is easily understood by analogy to the children’s story “The Three Bears”, in which a young girl named Goldilocks tastes three different bowls of porridge and finds that she prefers porridge that is neither too hot nor too cold but has just the right temperature.
The concept of “just the right amount” is easily understood and applied to a wide range of disciplines and can also be used to arrive at a correct valuation for a startup.
The Story Of Overvaluation
The word “valuation” has indeed become a buzzword; anyone who is in business cannot escape this word, and perhaps its popularity has increased via shows like Shark Tank, and while there are several other important aspects of a business, “valuation” tops them all.
So why has this word become so important lately – simply because the more valuation a startup can command, the more are the chances of acquiring an equity deal.
Now that we have the buzzword right, let us understand what valuation is exactly and why it is so important.
Valuation simply refers to a company’s overall worth, which is determined with the help of a few growth parameters.
While business valuation is significant, as you would have already guessed, but what makes it so?
A startup’s valuation is fundamental, and its multidimensional deployment has become a dilemma for growth in almost all possible areas of a startup; why?
Because the valuation of a startup has become critical in funding, acquisitions, investments and also for equity shareholding, and hence increasingly, startups are jittery over maintaining a sustained valuation.
Therefore, it would explain why the Indian startup Inc is so concentrated on getting a higher valuation and hence – overvaluation!
The Deep Dive Into The Abyss Of Overvaluation
Many seasoned entrepreneurs and founders agree that overvaluation is a peril.
Higher valuations are, in the majority, a result of overstating the size of the opportunity available for the startup in the market.
It is a potential trap, a never-ending cycle that many a startup finds itself in, an endless cycle of showing more than its actual worth, expecting more than what it should get!
So what is Overvaluation?
Why would startups show overvaluation of their worth?
What would motivate a startup to indulge in an overvaluation of its worth? There are several reasons for it.
1) Its A Game Of Large Capital, Founders Shares
Founders of those startups that have indeed indulged in overvaluation may have done so to keep the cash flow positive. The reason for the same is that a significant part of their valuation anxiety arises from the number of shareholders or equity shares.
While equities are essential for startups but not at the cost of the founder’s share, the harsh truth is a lack of funds or capital will stem their growth, and most of the funding is in the form of equity, as has been seen.
The founders are in a state where the more equity there is, the fewer shares the founders have. Hence, the best way to counter the increasing equity is by incrementing cash flow into the startup to keep their share high, and this cash flow is the reason for the sudden spike in the valuation of a startup.
Massive Cash Flow And Yet A Problem?
Now let us consider this scenario: a startup with a good number of investors and good cash flow to sustain the business; the overvaluation has done its job – but probably the employees have not.
The team is secure because cash flow is not a problem any more and hence has become lethargic, and the business does not perform as well as it should.
Typically, a company’s output is measured in the ratio of growth and burn. 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 considerable 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.”
Thus is it possible that this short-term overvaluation tricks more and more investors into the loop?
Yes, it does, But there is yet another “overvaluation trick” that is performed by both sides.
Corporate Investing – Overvaluation pitfall
Let’s be honest. Corporates have their own business goals. So, they are likely to favour overvaluation if it aligns with their business. You often see these investors assuring you that the accrued benefit will offset the overvaluation.
Overvaluation The Deadly Trap
Needless to say, a startup will undoubtedly want to push for a higher valuation since it would mean that one can raise the required amount of money without losing a lot of equity.
However, startups inevitably suffer from a valuation that’s simply too high.
1) End up with the wrong kind of investor. An extremely high valuation doesn’t necessarily mean the investor gets the startup’s concept. It could instead lead to setting wrong expectations and will ultimately lead to conflicts and many disappointments and may usually not end well.
Hence, a startup may attract an investor with a lot of money to spare but not one that’s super excited about the firm.
2) Give up long-term strategy. A high valuation might lead to short-term gain but can damage a startup in the long term. One might end up giving wrong signals to investors since personal income is paramount, not company success.
A high valuation increases expectations for the next rounds and makes it rather hard to keep increasing the valuation — you leave no margin for error, something startups should always do.
3) Forced To Spend More – Higher valuations may force startups to spend more, make needless acquisitions and even hire more people than required.
4) Misplaced Targets – One may be so caught up in the game of overvaluation that many startups step into the gear of increasing the business size, but at what cost?
Service, quality, and customer satisfaction may completely take a backseat. The only thing that remains in focus is unrealistic growth and expansion as the only way to make money.
5) Distance Customers and Partners In Business – of course, the most important is the customer, and what makes a customer stick is service, quality, innovation, value for money etc.
But focusing on other parameters rather than what a customer needs and wants is a recipe for downfall.
The same goes for partners in business, your success equals their success, and your downfall is theirs too.
Overvaluation The Over All 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 prominent example of this has been the overvaluation of ed-tech firms during covid. Post covid, the sudden downfall led to layoffs of over 400 jobs in each Byju’s and unacademy. Lack of innovation or obsolete business model and the double whammy of a slowing economy has caught these as deer caught in the headlight resulting in massive layoffs in the last few months.
No sooner do these firms reach a devaluation point; they have no alternative left but to ask the employees hired on an immediate basis to quit, as has been seen recently.
Conclusion: Startups and founders may benefit in the short term through overvaluation, but there is no doubt that it is a deep painful bite in the long run!