WeWork, a startup that had been one of Silicon Valley’s darlings was valued at $47 billion and had set its sights to get an Initial Public Offering (IPO) in late 2019. This startup was America’s most valuable tech startup. But as soon as WeWork sent its IPO registration papers to the Securities and Exchange Commissions, who in-turn posted the papers on their website, WeWork’s and its founder and CEO, Adam Neumann’s dreams started unraveling.
In a matter of 6 weeks, WeWork went from a $47 billion company to becoming almost bankrupt. This news comes in a year when startups like Uber and Lyft had underwhelming IPO’s. This proves that the public and the stock market feel that these companies are overvalued by rich investors and VC firms, such as SoftBank. In this article, we will look into how valuations work, how these companies are valued by VC firms and some other cases of startups being massively undervalued or overvalued.
How do valuations work and why do they matter?
Valuation is simply the value of a company. But the bigger question is: Why does it matter? It matters to entrepreneurs because it determines the share of the company they have to give away to an investor for money. At an early stage, the value of a company is close to zero, but the
valuation is a lot higher. Valuation at the start indicates the growth potential, and not necessarily the present value.
Early-stage valuation is often called an art rather than a science. But there are a few factors which influence valuation:
Traction: Traction is the number one thing that will convince investors. The number of users a startup shows that the market approves of the product, and the quicker the company gets these users, the higher the value of the startup.
Reputation: Reputation of the entrepreneur also matters a lot. Elon Musk’s new idea would get a high valuation, regardless of what it is. Entrepreneurs with prior exits often get high valuations. Sometimes people receive funding without traction and significant prior success. If people can project themselves as someone who gets it done, lack of traction does not matter much.
Revenues: Revenues are important to B2B startups. They make companies easier to value. Methods such as the Times Revenue are popular methods used to arrive at the true valuation of the company. This method determines the maximum value of a company through a multiple of current revenues for a certain business. The multiple may be one or two times more than the actual revenue itself, but this depends on the industry and economic environment.
Hype of Industry: As it has been seen in industries like Electric and Autonomous Vehicles, investors often pay a premium for these startups. A lot of investors enter these deals because they feel that these industries are the next big thing but more often than not, these industries tend to slow down in terms of growth.
For example, a lot of automobile companies like Nissan and General Motors had bet big on Electric vehicles. This led to further EV startups being heavily overvalued. However, the industry has not grown as expected because there have been only 2.6 million units of electric vehicles sold in 2019. It’s a far cry from the 2020 target of 5 million units that was set by many firms at the start of the decade.
Problems with High-Tech Valuations
Tech startups that became famous before they hit the public markets are often valued more than they are worth. No one has minded this because most people buy the brand, the name or the entrepreneur and not the companies’ growth or investment return potential.
The main challenge with big-name companies is that their valuations do not have any basis on paper. When a company tries to go public, it has to disclose various documents like the mostly weak balance sheet. This leads to a cut in the valuation either before or after the IPO, as seen with Uber and Lyft. Investors do not like this as this decrease in value reduces the value of their investment in the company, just like in the case of WeWork and Softbank. These investors often exit the firm or withdraw support, which creates a bad reputation for the company and makes other investors nervous.
Cases of Undervaluation and Overvaluation of Companies
When looking at overvalued companies, WeWork is a case in point. But there’s one lesser-known company, which is almost exactly like WeWork, only that it is profitable. This company is called IWG, formerly known as Regus.
IWG is valued at roughly one-tenth of the value of WeWork, which works out to be around $4.7 billion. WeWork had 6,04,000 workstations in August, compared to 6,02,000 of Regus.
If these companies are so similar, what is the difference between them?
The clearest difference between them is that IWG has had a more measured approach to growth. The company made an operating profit of £50.6 million on $1.59 billion in revenue. IWG’s share price nearly doubled since the beginning of 2019. By contrast, WeWork racked up an operational loss of $1.37 billion on $1.54 billion in revenues in the first half of this year, according to the IPO filing, after spending heavily in pursuit of growth.
The difference in the valuations comes from how WeWork describes its business model in the faux-tech lingo of “space-as-a-service” and its mission as “elevating the world’s consciousness.”
Conclusion
Hence it would be safe to say that in recent times investor speculation and big players in the investment field betting big on not-so-successful start-ups fueled by their fear of missing out has led to multiple rushed and unprofitable investments, culminating in heavy losses.
Even though in the investment space risks and losses are inevitable, it’s imperative for firms to observe prudence and ensure that there is a method to the madness.
WRITTEN BY:
Suchet Kumar
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