Why the Stock Market Affects Startup Valuations

In the startup world, valuations are starting to come down a bit.

By that I mean that new companies raising money today are being valued at lower prices than they were just a few months ago.

It’s not a dramatic move. This is something you’d notice only if you looked at multiple startup deals per day like Andy and I do.

So, why are valuations for new startups dropping, as compared to similar deals less than a year ago?

Mostly because the stock market is “correcting.” It’s the fear.

Even though we’re down only around 10% from highs, people are spooked.

Pick your poison:

  • China’s downturn
  • The Fed
  • Bernie Sanders
  • Donald Trump
  • The Middle East
  • Ukraine/Russia.

On top of these macroeconomic concerns, stocks have been in a bull market for a while now. Investors are expecting a pullback. And many don’t fully trust the “recovery,” which seems to have mostly affected just the stock market.

Of course, there’s no direct connection between stocks and startups. Startup investments don’t trade on an exchange (yet). They aren’t liquid like stocks. But they’re still affected by the overall market.

Whatever the cause, people are tightening up their finances a bit.

The result is more attractive deals, especially at the early rounds.

And it’s not just better for investors. In many cases, lower valuations are better for startup founders too.

That may seem counterintuitive at first. Let me explain.

You see, many companies that raise their early (seed) rounds at high valuations have trouble when it comes time to raise a Series A round.

Series A investors are picky. A company is expected to make serious progress with their seed money.

This is why many companies don’t make it past the seed stage. When a venture capital firm leads a Series A, they want to own as much of a company as reasonably possible. This can be difficult with startups that raised an overvalued seed round.

A startup that raised a high-priced early round often has it come back to bite them when it comes time for the critical Series A.

They may not be able to raise one at all. Or they may have to do a dreaded “down round.” That’s when a company’s valuation drops from one round to the next.

A down round is an all-around bummer. A morale-killer for employees. Down rounds have dealt a deathblow to more than a few companies.

So often it’s actually better for a startup’s founders if their first round is at a “low” valuation. The difference between a $5 million and $8 million seed round could make or break their Series A… because generally Series A investors don’t like overpaying.

Low Burn Rates Back in Style?

One reason early investors are spooked is that financing can be hard to come by in a down market. Especially for early-stage companies.

Companies with high “burn rates” – meaning they’re bleeding cash – are most vulnerable if things do get ugly.

This is yet another reason it’s wise to invest in some startups that are lean. Small teams doing a lot with a little. Founders who prefer to take it slow and steady.

Other startups choose to take on as much cash as they can get their hands on in an attempt to turbocharge growth. Sometimes it works, oftentimes it doesn’t. In an extended down market, this strategy gets harder.

Investors should always ask founders about their burn rate. What are their hiring plans? How aggressive are they planning to be with marketing? How creative are they with marketing? How much are they paying themselves? How long of a runway will they have after raising the current round (how long will their cash last)?

If this current downtrend continues, lean startups will likely outperform those with high burn rates.

A Healthy Correction

The larger point to all this is that lower early-stage valuations are healthy. New startups had started to get a little pricey again.

This is simply a correction (assuming it continues).

Bottom line: Lower valuations mean more bargains for investors.

Startup valuations fluctuate cyclically. This why we stress diversification not just across industries, but over time.

Spread your startup investments out over years. If anything, make more investments during market downturns.

Needless to say, you’ll get more bang for your buck. But it’s not as easy as it sounds. This is the opposite of what instinct tells us to do. You can read more on the psychological aspects of investing in this piece I wrote in August.

Good investing,

Adam Sharp
Co-Founder, Early Investing