Startups Got Hyper-Inflated Valuations In The Bubble: Zoho CEO
The Chief Executive Officer of Zoho, Sridhar Vembu, stated in a post on Twitter that “Startups that acquired hyper-inflated values in the bubble now face the threat of having to ‘guard’ those valuations.” This results in cost-cutting for the company’s employees and price rises for customers, Vembu added, which lowers both employee and customer satisfaction. He continued, “Bubbles are destructive.”
What does this mean for entrepreneurs and startups as the market is continually evolving and obviously not the same as it was a year ago? We predict that 2023 will mark “the beginning of an imminent but healthy recalibration phase,” despite being higher than pre-pandemic years.
Investors have grown warier as a result of the high inflation, the conflict in Ukraine, and the worry of a recession. VCs began extending their due diligence procedures while concentrating more on mature, tested late-stage startups. Early-stage firms attempting to raise financing for the first time to support growth and development have been impacted by these shifts.
When there is a lot of speculation surrounding a startup’s valuation, it is said to be in a start-up bubble. Even when the companies are burning through investors’ money for an extended length of time, they are still grossly overvalued. Simply said, the price paid by investors is disproportionately higher than the share’s value.
Without a doubt, 2021 set new records for investments, but first, let’s examine why.
Due to the massive amount of dry powder gathered from the record levels of VC funding in 2020, venture capital firms signed larger-than-ever checks for early-stage entrepreneurs. Many business owners struggle with the decision of where to put their company’s worth prior to a raise. Pre-seed and seed valuations have skyrocketed since 2020 due to an influx of capital from non-traditional investors and later-stage investors moving downstream.
The past two years have been a rollercoaster for startup valuations. The news for raising appears to be more gloomy as of late. Investors are investing record sums of money in startups despite a decline in 2022’s first and second quarters. It can be tempting to put all of your attention into getting the greatest value possible when you see other startups—especially rivals—raising money at exorbitant valuations. Weighing the short- and long-term effects of where you set your next valuation is crucial because raising money at a high valuation has both benefits and drawbacks.
It can be tempting to raise money at the highest valuation possible when the market is booming in order to profit from the frothy market. A longer runway and less time spent stressing about finding your next investor result from taking on more debt (which you can do at a greater valuation).
If there is a lot of competition, a high valuation denotes a current or potential winner in the market. Appearing to outperform the competition makes it simpler to close transactions, hire highly qualified staff, develop a product, and attract potential investors. Additionally, a higher value typically results in less dilution for you and your staff. Setting a high valuation provides benefits and can give a firm an immediate boost, but it’s not really that easy.
There were predictions that twenty startups in the field of technology will make their way into the stock market via IPO this year, but so far only Delhivery has confirmed its IPO in the last year. Due to the present global sell-off and the pressure from the Reserve Bank of India’s interest rate hike, the remaining corporations are unsure of how the stock market would react to them.
Last year, the unicorns’ most anticipated IPOs were Paytm, Zomato, Nykaa, and others. The worth of their shareholders has decreased at all of these enterprises. Zomato has lost $1.1 billion since its IPO, and Nykaa recently experienced a $1 billion loss. Due to the fact that the majority of startups experience losses, the EBITDA multiple is typically used to determine a startup’s value.
Retail investors anticipate the success of every company in their portfolio, whereas private equity anticipates only a select handful to survive the competition. Due to the high demand for unicorn IPOs last year, retail investors are now having second thoughts due to the decline in the price of publicly traded unicorns. They are concentrating on the business’s profitability.
Fintech, enterprise, tech, e-commerce, media & entertainment, and consumer services all have the potential for mergers and acquisitions because so many unicorns are overlapping in these industries. Similar to the Dot Com bubble, companies today are overpriced and burning through investors’ money without being able to develop a competitive edge over their rivals and new competitors.
To sum up
The value is ultimately what your company is intended to be worth, so if you raise money at a valuation you can’t grow into and accept more debt than you can handle, you’re putting yourself up for failure. Let’s examine some of the potential long-term, as well as immediate, negative effects.
For startups, things rarely go as planned, but in an ideal world, you would like to establish a pattern of raising money every 12 to 18 months, with each round being larger and at a higher valuation than the one before. Investors and potential employees’ perceptions of their chances to make money with you are damaged by flat rounds and down rounds.
Even more, founders are diluted by anti-dilution clauses that are triggered by down rounds, making the valuation of your prior round a hollow win. And that’s presuming you can raise again at all after falling short of your prospective value’s promise.
After a bubbly rise, exit alternatives may become more limited when looking further down the line. As you all presumably now know, the most common route to a successful exit is through acquisition, but most founders don’t begin to think about and plan for this very early on. Even angel investors seek returns of at least three times their initial investment, and if the value was exaggerated, investors have the power to reject transactions that fall short of their expectations.
So how can an entrepreneur decide on their next raise while keeping long-term objectives, fiduciary duties to shareholders, and other factors in mind? It can sometimes be better, in the long run, to forego the inflated valuation and instead negotiate alternative founder-friendly arrangements. Founders can employ a few provisions to ground their discussions. Here are some suggestions:
Financial conditions that preserve ownership for the founders and present investors, Post-funding, increase the number of available options for investors to purchase stock in the company, Must have a balance of equity and debt financing (70/30, say), Get rid of liquidation preferences and dividends in arrears, Controlling clauses that make things easier for the founders, Board meeting schedule, Decrease the number of founder shares that are subject to accelerated vesting, and Fair compensation.
Additionally, a realistic valuation will lead to the kind of long-term connections with knowledgeable investors that all business owners need to be looking for. For instance, attracting an investor with extensive industry knowledge could close crucial gaps that are holding back your business’s expansion. Some investors may be able to assist with business development initiatives or distribution arrangements. Inflated valuations can scare away the competent investors who are necessary to see a firm through to its eventual exit.
Simply said, you need a plan of action before you start raising money. The process of determining a valuation is more art than science, and in order to make the most of the alternatives available to you in the future, you need to strike a balance between being ambitious and being strategic.
Edited by Prakriti Arora