Its The Valuation That Kills You

Startups are saturated with risk. There’s technical risk that the technology doesn’t get built, co-founder risk that a falling out will damage a team, product-market risk that the company never creates something people want, and dozens more reasons why a startup can fail.

However, I think there’s a risk that doesn’t get its due attention, but is having a moment right now. One that is particularly relevant in today’s shifting financial markets. I’m talking about valuation risk, which I would describe as the risk that the company isn’t priced appropriately. While I would concede that this is less critical than some of the other factors I mentioned, there’s ways in which mis-pricing a company can have painful implications. This article will focus on that risk, those implications, and why this is more relevant today than any time in the last decade.

Lets dig in!

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How do companies get mispriced?

There is a pervasive perspective among founders that when you raise capital, you should reach for the highest possible valuation you can get. That’s understandable, when executives go out to raise funding, they typically optimize to reduce dilution as much as possible. After all, they want to maintain ownership of the company they’re making so many sacrifices to will into existence.

However, some founders are so effective at fundraising and the hype surrounding a funding round or industry can get so intense, that a company’s valuation in that round can balloon to something that might be extremely distanced from what would likely be considered more reasonable.

In itself, this isn’t an issue, after all that’s what markets are for, to find the price at which a buyer and seller agree that an asset is worth, the asset in this case being a company’s shares. However, a company that is valued far higher than other businesses in its “class" or “stage” has made strong assertions that it is much more mature or financially successful than those other organizations. If those implications turn out to not be true or even if there are hints that the company isn’t quite as exceptional as it has portrayed itself, then the return to reality can be particularly painful. That “return to reality” is also happening more frequently today due to the downward market correction we’ve experienced over the last two years.

I really like how early-stage space investor Jonathan Lacoste recently described this:

Why have company valuations changed so much?

The short answer is rising interest rates. Feel free to skip this section if it sounds familiar to you.

The most basic and fundamental way to describe a company is as an entity that generates cash for its owners both today and in the future. But how do you determine the present value of a company based on cash that will be generated two, five, or even ten years from now?

What’s typically used in finance is a discounted cash flow formula, where the value of future dollars are discounted by some amount, which is driven by a discount rate.

A result of this formula is that a dollar in the future is always worth less than a dollar today. Furthermore, as interest rates change, so does the amount by which a dollar tomorrow is worth compared to a dollar today. Without going into too much math and economics, the dominating impact of interest rates is that when interest rates increase, so typically does the discount rate. Consequently, when interest rates are high, a dollar in the future is worth less today than in an environment where interest rates are low.

Over the last two years, we’ve experienced a historically rapid increase in interest rates, which is having massive implications to how companies are valued. For many years while interest rates were essentially zero, a dollar tomorrow was worth almost the same as a dollar today. Therefore, a company that made no money today but promised investors that it would make tons of money tomorrow (or 5 years from now), could still be considered very valuable. However, in today’s environment with much higher interest rates, a company that provides profit today is worth waaay more than a company that has no current profit but promises a lot of profit in the future 

What we have experienced in the past two years of interest rates rising is a massive transition from a period in which companies promising future profits were previously considered valuable but are now considered much less so. This transition has been most felt in industries where companies were very unprofitable, but made promises to be highly profitable in the future. The space industry happens to fit that depiction very well, which why we’ve seen such a shift in valuations for publicly traded space companies from late 2021 to the present day.

Unfortunately, all of this was really out of the control of the companies themselves and the ground simply shifted beneath them. There was little any company executive could do to moderate this significant reduction in their companies’ valuations. Today, they simply run companies that are valued typically 50-80% less than two years ago.

So now that we understand why valuations have changed so massively, we can discuss how this plays out for a startups stakeholders, specifically the founders, investors, and employees.

What Happens in a Down Round?

A down round is defined as a funding round in which a company is priced at a lower valuation than it was in the most recent funding round. Given that company valuations have dropped so drastically due to interest rate changes over the last two years, down rounds are an inevitability for many mid to late-stage space companies.

In itself, that doesn’t sound that terrible, I mean publicly traded companies on the stock market have their valuations go up and down every minute. In private companies that have chosen to take venture capital funding and therefore have implicitly or explicitly made assertions that they are growing very quickly, having a downround is a painful process that impacts prior investors, employees, and founders.

What Happens to Employees?

Employees working at startups typically do not receive equity in exchange for their employment. What they instead receive are stock options, which is the opportunity to purchase that equity at a future time, while paying a previously established price. That price is equal to the most recent price at which the company was valued before the employee joined. And if the company’s current value is less than it was when the employee joined, then that employee is better off not exercising/buying the options and so the options are worthless.

This video from the startup accelerator Y Combinator I think best articulates the downside of being at an overpriced late-stage startup when they say “Most likely if you joined a unicorn that is late stage, the strike price of your options is going to be tied to the valuation that the company raised at. So if the company is sold for less or is overvalued, your options are likely underwater.” Here’s the whole video if you’re interested, and the part I’ve quoted is at 2:16.

What Happens to Investors

The most direct impact on previous investors is dilution. With a down round, the company's valuation decreases, leading to a larger issuance of new shares to accommodate the new investment. As a result, existing investors see their ownership percentage in the company reduced. That significant dilution can mean that the investor’s ownership can no longer provide fund-returning performance for the investor’s portfolio. That can make the investor’s ownership in that company so insubstantial that they’re no longer likely to support the company with their time or future funding.

Is There Anything A Company Can Do to Limit These Risks?

So we’ve established that experiencing a down round is particularly painful for an organization. Then how does a company, today, raise capital with confidence that they are doing so at an appropriate valuation, especially when there is continued uncertainty in company pricing, as well as ongoing hype in particular venture industries?

In a funding environment where it sometimes feels like no one knows what the “right” valuation is for a Series A, B, C, or later-stage funding round, I would argue that private investors can look to more liquid marketplaces where there is moment-to-moment repricing of company equity. In the tech world, that marketplace is most typically the NASDAQ stock exchange.

If you’re a private company valued at tens of millions, hundreds of millions, or even billions of dollars, if you want to know what you’d be valued at by public markets, just look at a public company with comparable revenue, profitability, and growth rates. One benefit of the recent SPAC craze is that it has provided us with about a dozen public space companies of varying levels of revenue, income, and growth. If there’s a big difference between where you are and where you’d be if you were publicly traded, then something is likely out of whack.

Let’s take for example a startup that maybe did $20M in revenue (annualized to $80M) in Q3 2023, and even grew in revenue by about 25% year-over-year. What do you think that startup would be valued at? Well, if they were a public company, they would be valued at $177M. How do I know? Because that company is Blacksky Technologies, a space company that went public through a SPAC in late 2021.

So if you’re a space startup that is doing less revenue, growing less quickly, is less profitable, but yet is valued at more than $177M, you may have a painful “return to reality” in your future as you seek to raise capital from late-stage growth investors or even go public. And it’s reasonable for your employees and investors to be concerned about that.

Of course, there’s always the possibility that interest rates decrease in the near future and we return to company valuations that are more generous than where they stand today. In that case, this post will retrospectively look more “doom and gloom” than was necessary. But for those of us without a crystal ball, this seems to be the world we’re living in and all we can hope to do is adapt.