Most startups were overvalued before 2021. Now it’s causing problems.

Bastian Hasslinger
Picus Capital
Published in
6 min readJul 27, 2022

Under normal circumstances, the higher the valuation of a startup, the better it is for all stakeholders involved. High valuations indicate success and the potential of a business. They attract new customers and new talent. They build a reputation.

And provided that a company’s valuation continues to increase, everyone will benefit.

As such, founders and investors have always been incentivized to believe in optimistic estimates of a company’s true worth.

Post-Money Valuations were inflated by market expectations in 2021, but they were also inflated by the underlying mechanics of the valuation model itself.

In order to navigate the impending challenges of a normalizing market, founders need to understand the impact of both levers.

The miracle year of 2021

For founders, employees and VCs alike, 2021 must’ve seemed like a miracle year. The initial caution that had been exercised at the start of the Covid-19 pandemic had been forgotten, valuations were rising, and funding was once again flowing freely.

In 2021, VC investment volume doubled to $643B, up from $335B the previous year. 2021 saw 518 new global unicorns vs. 134 in 2020, and 951 US IPOs vs. 431.

But just as the transition from 2020–21 showed us, things can change rapidly.

In 2022, share prices and tech company market caps are in sharp decline, thanks to rising interest rates, geopolitical developments and normalizing technology conditions. Deliveroo is down 54% YTD, Cazoo is down 79%, and Zoom — the poster-child of early lockdown success — is down 37% since 1st Jan.

In a normalizing market like this one, once-inflated valuations can become a big problem — particularly for founders, employees and early investors.

Why startups are — by definition — ‘overvalued’

To understand why inflated valuations are an issue, we need to first look at one of the underlying mechanics that causes them.

Unlike publicly-listed companies, whose valuations are constantly rising and falling, the valuation of a private startup will typically only change after the close of a new funding round. The calculation for the startup’s new value is fairly straightforward:

New valuation = (share price at latest round) x (total number of company shares)

This is known as the Post-Money Valuation model, and is commonly applied and accepted as the industry standard.

Let’s demonstrate how it works with an example. If a VC were to invest €10M in a business for 1M shares (a price of €10/share), and the total number of shares in the company at the end of the round was 10M, the Post-Money Valuation of the startup would be €100M (€10/share x 10M shares).

This approach might seem like the most logical way to value a business, but the model often implicitly overstates the true value of the company — even if the share price paid by the investor is fair. The reason for this: not all shares are equal.

New investors in a business will always look to limit their downside risk as much as possible — i.e. if things start to go badly, they want to be able to recover as much of their investment as they can. So, new investors will try to negotiate better conditions for themselves, and in exchange, they are willing to pay a premium.

How a floundering SpaceX grew in valuation

A great example of this is SpaceX’s Series D in 2008. After the funding round, the Post-Money Valuation of the business was 36% higher than the previous round, despite the economic downturn caused by the financial crisis, and several failed rocket launches. Why?

SpaceX’s Series D shares were issued with certain protections. In the event of liquidation, Series D investors were guaranteed to get a 2x return on their investment before any other shareholder would receive any remuneration.

This new share class was, by its very design, much more valuable than any other shares in the company — and thanks to the downside protection, investors were willing to pay a higher price.

When the Post-Money Valuation model was then applied to SpaceX, it treated all the shares as if they were worth the same (they weren’t), and the total value of the company was overvalued accordingly.

Why founders, employees and early investors have the most to lose

Despite its obvious failure to take the differences between share classes into account, Post-Money Valuation is usually an effective and sufficient method for calculating a startup’s valuation.

In a healthy market, with the company valuation likely to grow again with the next funding round or an exit, the inflated value is of little concern.

It remains fair too. Provided that a company exits at a higher valuation, every shareholder will receive a payout equal to the proportion of the company they hold. (i.e. If you hold 5% of a company that’s sold for €100M — you get €5M).

In the case of SpaceX, it was never an issue that the business was implicitly overvalued at that point in time. However, had it been sold at a lower price than its Post-Money Valuation, some shareholders — most likely founders, employees and early investors — would have found their stake to be worth much less than the PMV implied.

The harsh reality of 2022

In 2022, we find ourselves in a normalizing market, where below-valuation exits and down-rounds will be an unfortunate reality for many founders, employees and investors who benefited from the inflated valuations of 12 months ago.

For them, 2021 will cease to look like a miracle year, and will instead appear to have been a curse.

Some of tech’s biggest names have reason to be concerned. In less than a year, Klarna’s valuation has dropped from $45B (Oct ’21) to $30B (Jun ‘22), Canva’s from $40B to $27B, and GoPuff’s from $17B to $8.3B.

Those forced to exit or IPO at a lower price will share the misfortune experienced by the likes of Shazam and Blue Apron. Premium share classes will be protected, while others will receive much less. It’ll be the same situation for those facing bankruptcy too.

As for those able to persist at a lower valuation, their reputation will inevitably suffer, as will their ability to attract and retain talent. Suddenly, generous employee share options become much less appealing if their value drops by half, and question marks loom over their potential to return anything at all.

What lessons can we learn from the current situation?

While we’d all love for there to be some simple hacks to boost the value of your company, or halt a normalizing market, such things are fantasy.

However, the current situation acts as a harsh reminder for current founders, and a timely lesson for new startups at the beginning of their journey.

If you are to take anything away from the demoralizing market decline of the past six months, let this be it:

  1. Remember that any valuation is hypothetical
    The Post-Money Valuation of a startup is a strongly simplified approximation of its actual value — especially in the early stages, without strong revenue or an advanced product. It is only an “imaginary” metric — a belief in the future. A valuation remains nothing but a number on a piece of paper until it is realized by an exit.
  2. Assume your business is worth less than what it was before
    Due to significant changes in startup capital markets, your past valuation might not be rational today. With many emerging publicly trading tech companies down 50%+, there’s little reason to believe that your company will still be worth the same as it once was. Be aware of the changes in the market environment and act conservatively.
  3. Understand the value of the stake you hold
    Every share class is different, and so is its value. Be aware of the type of share class you hold and the impact that other contractual terms have on the value of your security. Metrick and Yasuda (Yale & UC), and Gornall and Strebulaev (Stanford), have proposed frameworks for understanding the terms that influence cash-flow rights for investors upon exit. This will allow you to estimate the value of each share class, and will provide you with a more accurate valuation of your company.
  4. Be cautious about accepting overly-protective share terms
    When negotiating future rounds, be aware of the trade offs. It might initially seem like a good idea to accept punchy contractual terms to maintain your “inflated” valuation, but you should exercise caution. Such terms ALWAYS lead to misaligned shareholders — with common shareholders (you and your employees) at the bottom of the pile.