28 Jul 5 Reasons for Startup Over Valuations
Over the last three years there has been a divergence between the amount of money invested in Startups and the amount of Startup Valuations. We have seen investments from Angel Investors all the way up to Series B rounds, go down by almost 50% since 2012. Meanwhile the average valuation of Startups has increased from roughly $9mm to close to $17mm in as much as time. It doesn’t take a lot of number crunching to see the reason investment is going down: Over-Valued Companies. We at Five23 have nailed down the top five reasons for this over-valuation when companies calculate their business valuation.
Hockey Stick Projections
If you have a startup or been involved with one in anyway, you have definitely seen these charts. Hockey Stick Charts as they are known in the investment world are simply exponential curves based on projected earnings or revenue of the company. These charts start at a very low and flat point. As time moves down the chart, the price starts to increase. Typically after a few months or years in the chart’s history the price starts to triple or quadruple. Quickly going from $1.5mm in revenue to $5mm, then to $20mm the following year. Once you reach the end of the chart a mere 7 years from where you started, the company’s revenue has reached a whopping $400mm.
While this is the dream and goal of every startup up entrepreneur, it is rarely realized by pre and post revenue companies. A more accurate chart is one that increases at a much more linear rate of a 161% per year. This means that if your startup is bringing in $1mm of revenue today, in all likelihood, you will bring in $2.6mm the following year. This rate of growth has been tried and tested by Five23 and seems to be the most accurate when creating realistic projections. Mind you, for post revenue companies it is vitally important to calculate using your actual growth numbers. Start your calculation using those numbers, then use a weighted value of 161% in your business valuation calculator to find an projected growth rate.
When White-Listing and valuing companies, Five23 only looks at realistic projections based on hard numbers and market data. This ensures a strong business valuation while concreting realistic and obtainable goals for the startup.
Bias Market Data
Market data is key when calculating a business’s valuation. It provides vital information and shows the path the startup will most likely follow throughout its life. These indicators can be quite powerful when used with realistic projections. The problem arises when only a section of the market data is viewed.
We’ve seen it time and time again, whether it be in startup decks, business plans or even pitch panels; entrepreneurs are plagued by bias data. It is great when you see 20% of businesses in your field see an average growth of 300% per year. However what happened to that other 80%? In most cases they go the other way. 50% saw a down year with negative growth and the remaining 30% closed their doors for good. This is the type of data that is essential, yet new companies owners seem to be blind to it. Viewing only a portion of the picture.
It has been said, “Don’t raise your voice, improve your argument”. When entrepreneurs use bias data they are raising their voice. When they show and prove how they are a part of that 20% which saw an increase, they are improving their argument. This should be the goal of every new business, show how you are better than the market and why you will beat it. This will increase your valuation calculation much more than bias market data.
It has been said that 80% of all investments are made on the team, not the company. We at Five23 have seen this time and time again. Great companies with poor leaders seldom move past a ‘Seed Round’. Yet a new company with spectacular leaders can have a lacking business model and easily see a ‘Series B’ raise and even an acquisition. This happens because the team is bought, not the company.
While being a great and eloquent leader is not an easy thing to learn, it can be done. However we at Five23 feel the most important element in this equation is the ability to see your team’s flaws and how to improve them. Investors want to see roadmaps. This includes a roadmap on how to improve your team. Being triumphant on a personal level when times get tough is a must, although showing how you were triumphant is even more important. Having the ability to handle large amounts of stress effectively and with confidence is key. In many cases new companies over-value their true ability in these matters.
When Five23 calculates a valuation using our business calculator, this human factor plays a part. It can raise or lower your company’s valuation based on a few key factors. Mind you, the value is weighted to ensure a high amount of accuracy.
One of the most detrimental things that can happen to a startup is having a bloated vision of self-worth. While having great self-esteem is a must, having it too high can cause a negative effect. Especially when calculating a valuation. We’ve seen it time and time again. An entrepreneur walks into a meeting stating that the coming is worth ‘X’. The problem is there are no solid figures to back it. They see what other entrepreneurs have been able to do and think they can do the same. We hear it all the time, “We will be the next Google”. And maybe you will be, but odds are the startup will not.
We at Five23 call this Unicornism: the blind belief a startup will become a unicorn. This can happen even to the most realistic entrepreneurs. However the problem arises when this belief is factored into the valuation. This is why having a third party do your valuation is so important. It takes all the emotion out of the equation and focuses on the hard data.
All companies raise money for a reason. Either they want to hire more talent or maybe set up a production line. While there are necessary funds required for such ventures. The number should not drive the valuation. Basically, don’t set your valuation at $20mm because you need to raise $5mm and don’t want to give away more than 25% of the company. Startups rarely receive funding this way, sadly it is quite common to do the business valuation calculation in this manner.
By far this is the biggest mistake a company can make when raising capital. That’s why Five23 takes it so seriously. We take into consideration the funding needs of the company to reach its next goal. However never at a cost to the valuation and the ability to raise funds.