Why Are Startup Valuations Falling?

Are Startup Valuations Falling
When startups begin seeking larger investment options, a key factor in their search is their valuation. In a startup valuation, a financial model is used to estimate how much the startup is worth depending on its current state, market forecasts, and other data. But data shows startup valuations falling significantly in 2022.

This trend is raising many questions among growing businesses and investors alike, especially after the particularly high valuations seen in 2021. Let’s take a closer look at why startup valuations are falling, what’s causing the change, and how careful startups can turn this into an opportunity.

What Do Experts Think About Startup Valuations Falling?

There has been a lot of discussion about startup valuations in general, as well as the current fall. It’s likely that several different factors are involved. Those include:

An expected correction following 2021.

2021 saw startup valuations rise to very high levels. The restrictions and limitations caused by COVID-19 were starting to end, and a new wave of growth was expected. This in turn increased excitement and high market expectations for new businesses that hadn’t had a chance to perform yet. The result was very high valuations, which in 2022 saw some significant correction to more standard levels.

Issues with the startup valuation model itself.

How do you measure the value of a company when it isn’t public? Two key parts are future earnings – which can be difficult to predict – and the results of the latest round of financing – share price multiplied by the current number of company shares. That can lead to a lot of value inflation and often encourages overinflation, especially in hot markets. Some believe that investors are beginning to react to this more strongly, leading to falling valuations and more cautious lenders.

Performance of current stocks, especially tech stocks.

As Forbes notes on tech stocks, these particular stocks have fallen back year-to-year, and investors are acting with more caution. Tech stocks may have more impact on the startup market than most industries, and the caution of tech investors may be leaking into venture capitalism and related investments.

Interest rates are rising.

The Fed has repeatedly raised interest rates in 2022 in an effort to fight inflation and keep the dollar strong. One side effect of this process is that borrowing becomes more costly, and markets often turn more bearish. This, too, can limit startup capital and decrease valuations.

Inflation itself.

High inflation seen in the post-pandemic world is affecting not only purchasing power, but also encourages cost-cutting and can make the negative cash flows of startups look more dubious. This is particularly true for ventures creating luxury goods or other products highly dependent on elastic demand. It’s no surprise, then, that the inflation numbers we’ve seen in 2022 have impacted startup valuations and willingness to invest in new businesses.

What Do Falling Startup Valuations Mean for Businesses?

That depends on the business and its current round of funding, among other things. For some businesses, especially those in the early stages of investment, little may change. Startups in dependable, predictable industries may not notice negative effects from this trend, at least not currently.

Companies in later rounds of funding after their seed funding are more likely to see an impact, especially those in their last round of funding. Here is where investors will be most cautious about high valuation numbers and valuations are seeing the most significant declines.

There’s also a fear that, for some ventures, valuations may drop so low that they cannot secure funding, or that they won’t be able to find sufficient funding for their plans.

Are Startup Valuations Falling Always a Bad Thing?

No, especially when startups were previously overvalued, and that appears to be what happened in 2021. As we’ll explore below, startup valuations falling can also provide businesses with additional options to improve and reassess.

What Can Businesses Do in Response?

Lower valuations may represent initial challenges, but there are plenty of opportunities for startups that are willing to do some financial analysis. This may be a good time for strategies like:

Optimizing current cash flows and focusing on profitability.

This may be especially important for cash-hungry businesses that really need strong current sales numbers to help wow investors. It may be time to pull back from expensive growth strategies and focus on core operations to reach neutral cash flows and really prove the viability of the business.

Getting smarter about investment and loans.

Startups can use this time to do more in-depth research into their market, get more accurate market data, and create a better profile for their company to impress investors and lenders. They can consult financial experts and end up with a better plan and more ways to impress investors with their acumen.

Focusing on competitors.

Lower valuations can curb expectations of growth, but that may also open the door to claim more market share. Companies can take this time to focus on taking opportunities that their competitors miss.

Work on finding a high-quality investor.

When businesses are overvalued, they can receive high offers from a variety of investors – but during this crucial period of growth, not all investors are suitable for the venture. This may be a good time to focus on communicating with investors and finding one that understands the industry and will be able to facilitate growth.

Taking a break from investment.

Ventures can always shift their roadmap for their next investment round. Businesses waiting on a certain funding target can continue to wait, keep improving their business, and see what valuations look like after a year or two.

When looking for advice on what startup valuations falling means for you and your business prospects, get in touch with the financial experts at 5th Line Capital. We are here to help you with the insight you need to plan for your future successes.