Valuation horror stories and how to avoid them

Building a startup is a rollercoaster ride, but nothing quite compares to the ups and downs of company valuation.

Just when you think you've cracked the code and your startup's worth is soaring, something unexpected can send it plummeting back to earth.

Valuations aren't just numbers pulled out of thin air - they're influenced by a complex web of internal and external forces.

Some you can control, others you can't, but all have the power to make or break your company's perceived value.

Read on to learn more about the factors that can unexpectedly slash your startup's worth, complete with some cautionary real-world anecdotes. 

Valuations: what are they and how do they work?

Before we dive into what can go wrong, let's recap how valuations work and what influences them.

At its core, a valuation is an attempt to quantify your company's worth.

But it's not just about your current assets or revenue – it's a complex calculation that considers your potential for future growth, market conditions, and a host of other factors.

Common valuation approaches include Discounted Cash Flow (DCF) for companies with predictable cash flows, Comparable Company Analysis and Precedent Transactions for benchmarking against similar businesses, and the Venture Capital Method for early-stage startups.

However, the valuation process goes beyond numbers alone. Don't underestimate the impact of a strong team, current market conditions, and your intellectual property portfolio and potential.

When valuations go wrong: tales from the startup world

Let's dive into some startup stories that illustrate how quickly a promising valuation can unravel.

The funding faux pas

The age-old advice, "don't put all your eggs in one basket" applies to startup funding too.

Take it from Kev Price, co-founder of Reframed, who learned this lesson the hard way. In a blog post titled "From £4 Million to Broke: This is Our Startup Horror Story", Price recounts:

"At that board meeting we celebrated having £350k investment on the table at a £4 million valuation. Which was, at that time, considered to be the ideal round of investment for us. Two weeks after that board meeting we had no staff."

What happened? They put all their faith in a single investor who turned out to be a fraud. The supposed investor, Simon Wood (or Simon Wilson, as they later discovered), had spun a web of lies about his background, financial capabilities, and intentions.

Price continues: "It slowly dawned on us that the financial forecasts we were basing the raise on were useless. It was based on information from Simon on adverts that were not real, and deals that did not exist. The financial model was broken."

It illustrates how a valuation can be built on sand if it's based on false or unreliable information. In Reframed's case, their £4 million valuation evaporated overnight when the truth came to light.

To swerve this, make sure to diversify your funding sources and always, always do your due diligence.

Don't let the excitement of a potential investment cloud your judgement. A solid valuation is built on real data and genuine market traction, not on the promises of a single investor.

The 'fake it till you make it' fallacy

There's a fine line between optimism and delusion. Crossing that line can spell disaster for your valuation.

Take Theranos, for instance. Once valued at a whopping $9 billion, the company's worth plummeted to zero when it was revealed that their revolutionary blood-testing technology was more science fiction than science fact.

Elizabeth Holmes, Theranos' founder, became the poster child for the dangers of the "fake it till you make it" mentality. Her conviction on fraud charges serves as a stark reminder that while ambition is admirable, it must be grounded in reality.

The takeaway? While it's great to dream big, your valuation has to be realistic.

Investors aren't just buying into your vision; they're buying into your ability to execute it.

Overpromising and underdelivering aren't just bad business practices (and ethically questionable, of course), but can have serious legal consequences and completely tank your company's value.

The customer concentration conundrum

Relying too heavily on a single customer or product can spell disaster for your valuations.

Why? Because it’s risky. Valuations mirror the inherent risk present in your startup. A founder who experienced this firsthand shared on Reddit:

"Found a video marketing company 3 years ago. Got to proof of concept and made decent money with 1 employee. Met an experienced entrepreneur and offered his advice/participation for 51% to grow the company in no time...."

"I trusted him we found funding for over 60k…Account managers didn't manage to close any deal in first 3 months ran out of money my co-owner didn't believe in the business anymore had to buy him out. Got left with over 60k dept to a lot of friends and family."

This story highlights several valuation pitfalls: over-reliance on a single revenue stream, rapid expansion without a solid foundation, and the dangers of giving up too much control too quickly.

From a valuation standpoint, customer concentration is a major risk factor. If a significant portion of your revenue comes from one or a few customers, your valuation will likely be lower to account for the risk of losing those customers.

The lesson? Diversify your customer base and product offerings.

Investors want to see that your business can weather the storm if one client jumps ship or if market conditions change.

The transparency tightrope

There's a delicate balance between protecting your secrets and being transparent with your investors. Lean too far in either direction, and your valuation could take the hit.

Jeff Bussgang, a venture capitalist and entrepreneur, puts it this way:

"Founders should take a page from [Raymond Thomas] Dalio's book (an American hedge fund manager) and embrace radical transparency with all of their stakeholders, especially their investors."

"Some defenders of the founders of Theranos and FTX claim that they were perhaps over their heads and inept rather than corrupt."

"Whatever the case, today's founders can not only avoid similar pitfalls, but more importantly drive greater alignment, opportunity, and ultimate value if they were to simply embrace accountability and transparency as stewards of others' capital."

The key is to find the sweet spot between being open enough to build trust and not so open that you're giving away the farm. This means being honest about your challenges and successes.

Transparency (or lack thereof) can have a big impact on your valuation.

Companies that are open and forthcoming with their financials and operations often command higher valuations because they're seen as lower risk. Otherwise, investors might price in the risk of the unknown.

Market mood swings

Sometimes, it's not you. It's the market. Economic downturns, industry disruptions, or even global pandemics can send valuations tumbling across the board.

Consider the case of WeWork. In 2019, the company was gearing up for an IPO with a valuation of $47 billion.

But when investors took a closer look at the company's financials and business model, that valuation quickly crumbled. The IPO was postponed, and WeWork's valuation plummeted to less than $8 billion.

While WeWork's issues were partly of its own making (including questionable leadership decisions and an unsustainable business model), the company was also a victim of changing market sentiments.

Investors, who had previously been willing to overlook high cash burn rates in favour of rapid growth, suddenly became more cautious.

This can work in reverse, too. Artificial intelligence (AI) is an excellent example. Generative AI startups are attracting billion-dollar valuations with no products just months after being founded.

Some are calling the new Gen AI sector a bubble – a uniquely high-risk investing environment that isn’t well-grounded in reality.

If AI delivers on its promises, these valuations will be justified. If it doesn’t, which some investors are fearing right now, they’ll drop like a proverbial lead balloon.

The point is, while you can't control the market, you can somewhat prepare for volatility.

Keep a close eye on industry trends, maintain a healthy cash reserve, and have contingency plans in place.

Your valuation will thank you for it.

The scalability struggle

Investors love scalability. If your business model doesn't demonstrate the ability to grow efficiently and rapidly, it can seriously dampen your valuation.

A startup founder shared their experience on Reddit:

"Found an academic research publishing platform a few years ago that had a bunch of users, a bunch of organic work, and no revenue model. Folded in debt and all the research papers got deleted then realized it would be better as a nonprofit."

It’s a common obstacle: building something people want to use but struggle to monetise effectively. While user growth is important, investors also want to see a clear path to profitability and scalability.

Scalability is critical for your valuations. Investors are often willing to pay a premium for businesses that can grow rapidly without a proportional increase in costs.

This is why software companies, for instance, often command higher valuations than service-based businesses.

To beat this, focus on building scalable processes and technology from the get-go.

Look for ways to increase revenue without proportionally increasing costs. Most importantly, you should have a clear, viable revenue model before you start seeking investment.

Legal landmines

Legal issues can be a huge drain on your company's resources and a major red flag for potential investors.

Consider the case of Uber in 2017. The company faced a series of scandals, including allegations of sexual harassment, a lawsuit from Google's Waymo over stolen trade secrets, and investigations into its use of software to evade law enforcement.

These issues led to the departure of several top executives, including CEO Travis Kalanick, and dented the company's valuation.

From a valuation perspective, legal issues are a double whammy. First, they can be incredibly expensive to resolve, draining resources that could otherwise be used for growth.

Second, they create uncertainty, which investors dislike. When valuing a company, investors will often discount for potential legal liabilities, even if they haven't materialized yet.

To avoid these pitfalls, make sure you're dotting your i's and crossing your t's from a legal standpoint.

This means:

• Protecting your intellectual property
• Ensuring compliance with all relevant regulations
• Creating a company culture that prioritises ethical behaviour
• Being proactive about addressing any potential legal issues

It's about creating a company that investors can trust to operate ethically and responsibly – and leaving no skeletons in the closet to be uncovered when investors conduct due diligence.

Overcoming valuation challenges

Company valuations can be a bit crazy. You can control some aspects, but a degree of interpretation and speculation is tough to truly master – especially for a first-time founder.

However, by learning from others' mistakes and keeping a keen eye on these potential obstacles, you can steer your startup towards healthier valuations.

And if you're looking to clearly document your company's worth and prepare it for funding, Vestd has got your back.

Our platform offers company valuations as standard with our share scheme plans, making it easier and more cost-effective to manage your company's equity and understand its true value.

Book a call to speak with us today (for free).

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