Hackernoon logoLower Valuations Explained: Should Entrepreneurs Care? by@faloppad

Lower Valuations Explained: Should Entrepreneurs Care?

Daniel Faloppa Hacker Noon profile picture

@faloppadDaniel Faloppa


This article was originally posted on Equidam

“Morgan Stanley marked down it’s Flipkart participation[1]”, “Fidelity slashes down more startup valuations[2]”, “VCs say they’ll be more careful with new investments[3]” and the list goes on and on and on. Opinions bounce around the Internet like lights of a mirror, and when content aggregators, AMAs, blogs and newsletters all republish the same articles about the market change, the noise becomes very undistinguishable from the signal.

So, are valuations really going down? And if so, why should you as a founder, entrepreneur, or business owner worry?

If you need to refresh your knowledge on valuations and how they are determined take a look at our article Startup Valuation Methods

First things first, yes, there have been markdowns on valuations, so much that CB Insights published a live list of unicorns that lost their horn (you can find it here). Many called this a reversion to the mean, and to some extent it is, together with the obvious culmination of three main trends:

– Valuations are not real in the first place

– Winner-takes-all mentality gets a reality check

– SaaS is getting more crowded

And now a few words on each, because it is impossible to understand the current situation without understanding the events that led to it.

These valuations are not real in the first place

There has been more and more discussion on the fact that large private investments at high valuations are not real indicators of the fair market value of the company. These valuations are determined by negotiation and contracts between private parties, in a market that is far away from liquid and with clauses that put these contracts far away from common equity.

But let’s take these points separately:

Negotiations take place between two private parties that have specific interests in a specific company (they might want to acquire it, partner with it etc). These secondary effects of investing, called synergies, can drive the final valuation away from the fair market value of the company.

The market in which these negotiations happen is far away from liquid. In a liquid market, large amounts of the commodity in question, can be bought or sold with little effect on the price. In an illiquid market, like the one created by the few top startups, and the only investors deep-pocketed enough to participate, each large transaction has a large effect on the price. That is why startups publicly open rounds on bloomberg or the wall street journal (see slack’s latest efforts). This way, they increase demand by keeping supply constrained, in an effort to increase price.

And last but not least, these contracts are far away from common shares. What does this mean? When we make a valuation analysis (e.g. on Equidam.com), we take into consideration the future potential of the company, compare it with similar return opportunities, and calculate its fair price. Another way to estimate valuation (and write about it on a blog) is to look at percentage of equity the investor bought for a certain amount and work out the valuation from there. We then use this valuation and compare it with a fair market value, not understanding that we are comparing apples with pears. Private contracts are indeed a different product compared to straight up equity. Some (Sam Altman) say they are actually closer to debt contract. And a logical question comes to mind: If the investment is really closer to a loan, does it make sense to talk about valuation at all? It really doesn’t.

Winner-takes-all mentality gets a reality check

In the past 10 years, investors have been adopting more and more a winner takes all mentality (with few notable exceptions). By betting on less horses, and making sure you get on the really good ones, they increased their propensity towards risk, and lowered the one towards diversification.

Despite all our efforts, human beings remain biased. And after overnight successes like Facebook, Whatsapp, Uber, nstagram etc, there has been (IMO) an over-reaction towards the winner takes all mentality.

When a supposed winner is discovered, it can raise almost unlimited amounts of venture capital, at very high valuations. With great power comes great responsibility, though. And the supposed winner has to keep up with its fame.

As it so happens, more and more of the supposed winners are struggling with the growth required by such bets (Zenefits). As a consequence, investors are adjusting their mentality, and spreading their bets more wisely, refusing higher valuations, and realising that maybe sometimes they overpaid, for winners that do not win as often as it would seem.

SaaS is getting more crowded

Kurt Leafstrand wrote a great article about SaaS and about how not everything that sparkles is golden. A lot of the past years success has been brought by SaaS companies. Large industries like proprietary web infrastructure, payments, HR, CRM etc got revolutionised and created large companies (Salesforce, Veeva, etc).

Most of this success was driven by the power of renting over buying. When a person or a company buys a house it is harder for them to take the first step, but once the decision is made, they are likely to stick to it. Now software, similar to houses, ages. Software however ages much faster. And that is what happened to a lot of “houses” bought by large companies. Now that there is a new player on the market, SaaS, everything is rentable! Consequently, this makes the switch much easier than before. It is clear how easy gains could be made by relatively small companies that grow fast, and quickly eat market share from large established players.

A few years go by and the market adjusts. Now you can easily find 5 companies for any category of SaaS you can think of. This in turn is making large (abnormal) profits rarer.

And now the big question…

Should you care about it?

In my opinion, the only founders or business owners that should care, are the ones that were after the hype fundraising. For founders that look after building a solid business, based on market positioning, revenues and solid unit economics, this new environment should not be of much concern.

By looking after every change in valuation, reacting to it, and posting it everywhere, we are falling in the 2008 trend of using finance as a goal, and not as a mean. Fund-raising, valuation, unicorns and billion dollar investments are a mean for companies to overcome the cash flow imbalance between building the scale and making revenues and profits. If they start to be seen as the end goal, we’ll be very disappointed with valuations going down, very happy about valuations going up, and overall much less concerned about making a real difference in the world.

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