The Myth of the Startup Valuation

Startup founders and investors often obsess over valuation - the estimated value of a company used to determine equity stakes in funding rounds. However, valuation is merely a theoretical exercise that diverges from the hard economic reality of share price. Higher valuations seem to validate startups’ potential, regardless of shaky economics. But valuations often derive from vanity metrics like user growth, total market size, or flattering comparisons to popular tech giants. Hockey stick projections do not guarantee actual viability. This valuation obsession rewards perceptions more than tangible commercial success. It also pressures founders to focus on fundraising and short-term growth over sustainability.

What is Valuation?

Valuation is a calculated appraisal of a company’s worth based on growth projections, addressable market size, competitive advantages, and other forward-looking factors. It's a best-guess number used to allocate equity during fundraising rounds. The use of the word "valuation" is however misleading when discussing startup fundraising because it implies an objective, calculated value assessment. In reality, startup "valuations" are highly speculative and not grounded in standard valuation methods or hard metrics. They derive from negotiable assumptions and comparisons not rigorous analysis. Rather than imbuing these estimates with undeserved credibility through the label "valuation", it may be more accurate to simply call them “prices” - the amount of money investors are willing to pay for equity based on their own subjective perceptions and risk tolerance. Using the no-nonsense term “price” helps strip away the facade of false precision and reminds us that these deals currently lack a true objective basis for quantitative valuation.

Why Price and Valuation Diverge

Share price is what someone actually pays for equity in a transaction. Price depends on supply and demand at that moment. Valuation is a theoretical exercise. In private markets, share prices are not established through competitive bidding. Purchase terms are negotiated, often with only a few interested investors. Prices can thus diverge from valuations due to lack of price discovery. And valuations are often just aspirational estimates of the future rather than hard-nosed assessments of risk. As a startup proves itself, there is less uncertainty so investors pay higher prices for remaining equity.

The Role of "Price" in Fundraising

During funding rounds, founders and investors use price to negotiate percentage ownership in exchange for capital. Higher price mean founders have to give up less equity. However, price often increase in future rounds. So early investors with lower price get more equity per dollar than later investors at higher price. Price does not reveal precisely what a company is actually worth. It just helps align incentives and expectations for financing purposes.

Beware the Down Rounds

Another reason to disregard valuations is the specter of down rounds - future funding at lower prices. This can happen when milestones fall short of projections that inflated early prices. Down rounds force founders to surrender more equity for additional capital. And they can create tension between early investors at high prices and later investors at more reasonable prices. Founders must then reckon with more diluted ownership and devalued stock options. These are distractions from focusing on the strengths of the business itself rather than its fundraising optics.

Bubbles Burst, Fundamentals Remain

Excessive valuation hype creates bubbles when founders realize they cannot scale their businesses enough to justify inflated startup prices. Eventually reality catches up. This phenomenon is not new - it recurs throughout financial history in episodes like the dot-com crash and current AI hype cycle. When capital flows freely, speculation runs rampant, until money slows and struggle to deliver sets in. But companies that focus on building strong operations can outlast downturns in broader markets. If the business model works, share prices will reflect that in the long run regardless of broader industry cycles.

What Really Matters in the Long Run

Ultimately, valuations do not determine the true value created. Share prices over time reveal what a company is actually worth. Prices depend on how competitively a startup executes on its vision, not financial modeling. Delivering real products, users, revenue, and profits is what builds value - not passionate pitches or press coverage at inflated valuations. Founders should focus on sound business fundamentals, not chasing higher valuations and fundraising hype cycles. Building strong companies will earn returns for shareholders in the long run. Startup founders should ignore superficial valuations and focus on creating real value. Investors also need to look beyond headline valuations to evaluate investment potential based on business fundamentals and execution ability. Valuation is not value. Only strong companies whose share prices reflect true intrinsic worth can deliver sustainable returns.

Tune Out the Noise

There will always be hype in startup ecosystems, with shifting forces like high valuations distorting perceptions of value. But strong founders focus on execution, not vanity metrics. Rather than chasing flashy headlines, ask hard questions about how valuations were derived, and whether their underlying assumptions are credible and realistic. Build models valuing companies on actual revenues and profits to sanity check claims.

Ultimately, trust in your abilities to build products and services people want at prices they can afford. Valuations will come and go and share prices will fluctuate, but strong companies persist. Keep your eyes on the horizon, not the headlines.