WHY ARE STARTUP VALUATIONS SO HIGH?

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One of the most common areas of shock when approaching the world of investing in high-potential innovative companies is the million-dollar valuations of companies. Startup valuations can be high because they are often based on the future potential of the company rather than its current performance. The idea behind investing in startups is that, if the company grows and develops as planned, the valuation will multiply and the initial investment will turn into a significant return. Therefore, a high valuation reflects the investor's confidence in the future success of the company. It is common to find companies that are just starting to turn over and have a valuation of more than one million euros, which, compared to the more traditional economy, is absurd.

The motivation for these assessments is twofold

• Different models. A more traditional company grows in a linear fashion, i.e., in its business model, costs and revenues grow evenly (to sell more, you have to produce more). However, high-potential innovative companies always have business models with the capacity for exponential growth. In other words, they are scalable models (+) where costs do not grow in line with revenues and are therefore able to generate growth by several orders of magnitude, without their costs increasing much (usually thanks to technology). This implies that it is impossible to value a company with high potential with traditional company valuation models. (e.g. multiples on EBITDA), as these are designed for non-exponential growth, and not for companies capable of growing 10-fold in a few years, sometimes in months (see+ TIP).
• Dilution (+). These types of businesses are somewhat similar to R&D companies: they require investing a lot of capital at the beginning, with hardly any revenue generation, in order to generate explosive growth later on. If we were to value one of these companies using traditional (accounting) methods, we would be forgetting the spirit of the company, the scalability, the exponential growth and the value of the idea-team-execution equation. That way we would find that Whatsapp or Instagram would have negative valuations in their beginnings, when in fact they ended up being worth and being bought for many millions of euros. 

For example:

Let's imagine a company with a high potential but which currently has a turnover of €1,000 per month, so we decide to value it at €100,000. If we invest €150,000 in that company, we will obtain the 60 % (150,000 / 250,000 post-money valuation), and the founders in their first round of financing would no longer be majority shareholders (between all of them they would have a 40%). Therefore; What incentive would they have to continue working for years in a company with a high probability of failure rate and of which they have a small percentage? It is therefore common that, in an investment round, at most, the company decides to divest between 15 % and 25 % of its capital.

IF WE TAKE IT TOWARDS VALUATION, VALUATION GROWS PROPORTIONALLY:

If 150.000 € is 20 %, the 100 % will be 750.000 €. (their pre-money valuation (see+)).

However, it is important to keep in mind that the valuation of a startup is subjective and may vary according to the perception and expectations of each investor. This is why startup valuations can be very high compared to other, more established forms of investment.

Reasons why startup valuations are rising:

One of the relevant changes in 2021 in Spain was the general increase in the pre-money valuations of companies in the transactions carried out. This is not just a Spanish phenomenon or a phenomenon of the angel investment sector, but has also occurred in the rest of Europe and the United States. In Europe, the average valuation of startups that received angel and seed funding increased by €4 million, increasing by 30% compared to 2020.

Investors' fear of missing out on good opportunities contributed to their signing significantly larger deals, especially in those companies showing early traction. This phenomenon is not unique to early stage, but in the more advanced stages of venture capital, a number of new European unicorns have also emerged. In total, there are already 128, with a combined valuation of 329.7 billion euros, almost three times their value in 2020 (Pitchbook, 2022). In the United States, valuations in the angel (unseeded) segment have risen sharply (see figure).

As can be seen in the graph below, the median has reached $7.4 million, with the average jumping to $23 million due to the effect of large deals involving venture capital funds. A quarter of the deals exceed $19.2 million. Spain has also seen a significant increase in valuations in 2021 compared to 2019 for both seed stage (see Figure 8) and pre-Series A (see Figure 9) investments, mainly due to the overheating of the supply of available capital.