Startup IPOs Just a Valuation Bubble
Case Study: Valuation | Purpose | Funding Round | Locking Stock | Trap
When a large number of startups are listed on the stock exchange, everyone’s stock begins to fall after a few months. Startup entrepreneurs, venture capital, banks, and promoters all profit from this, but the average investor is out of luck. We begin investing without thinking as soon as we see news of an IPO on news channels, advertisements, influencers, or social media, and our money is drowned in the greed of listing gain.
Is there something wrong with IPOs in the startup company, or are they a rat trap?
Over Valued
Some similar characteristics have been seen in startups with market capitalizations in the billions of dollars, where their stocks have been overpriced. Because of this overpriced stock, it does not perform for a year or two and drops in price by 50%-60%.
- Let us try to figure out what the story is…
- Why startups are overpriced when they are listed on the market?
Players
There are four players at the beginning of the investing industry:
- The company’s founder
- Venture capitalist — someone who invests in new businesses. similar to Shark Tank
- Investment bank — Allow the firm to raise capital.
- You and I as Retail Investors
The 4 Participants’ Common Purpose is to Make Money…
- When founders sell their stock, they make money.
- A venture capitalist makes money by purchasing and selling stock.
- Investment banks make money via service fees. For example, when an investment bank raises funds, it charges fees on the amount raised.
- Retailers make money by listing gains and selling stock in an initial public offering (IPO).
Liquid Wealth
Paper wealth exists between the founder and venture financing. Their primary purpose would be to turn paper assets into liquid assets. Real money is represented by liquid wealth. They use the earnings from the investment for other reasons after they have taken it.
Example
Skyhorn is a company that you and I co-founded. Our company’s revenue is $5 million, and we need to raise capital to grow rapidly. We will contact an investment bank to find investors in order to raise funding. The investment bank will attempt to achieve the highest valuation ratio possible over $5 million in revenue. By chance, we multiplier a 10x increase. This will raise our company’s market valuation to $50 million.
The investment bank will impose underwriting costs ranging from 3% to 4% on whatever capital we raise.
JIOR Venture
Our company receives Series A investment from JIOR Venture. JIOR provided us with a $5 million fund. JIOR will be required to contribute 10% of our company’s value of $5 million. For a 10% investment at a valuation of $50 million, I will dissolve my 5% and your 5% stakes.
In this case, your query will be how you obtained a 10x multiplier and what factors affected it.
5 FACTOR…
Rate of Industry Growth
What is the growth rate of the fashion sector if our firm is in digital fashion? It is determined after deep evaluation.
Total market reachable
How huge you are in the market refers to how much of the market region you have covered. The more the area covered, the greater the advantage.
Serviceable Market
How many items does the market have the capability to service, such that when there is a need, the market can meet that demand? Exporting should be straightforward.
Scalability
How scalable is the startup? It should not be limited to a few specific locations, as this makes it tough to expand beyond that. The larger the size, the larger the firm can grow.
Operational Leverage
The expense of developing a platform for our digital fashion company will only be incurred once. There will be no need to rebuild the platform after that. It has a strong operational leverage. To boost revenue, the corporation must raise product prices.
After considering all of these factors, we will multiply any money earned by Multiplier x. You will be given the market value as an answer.
Revenue x Multiplier = Market Value
Focus on Revenue
The startup founder does not control the multiplier. Revenue is being prioritized. Revenue is something that every investor is concerned with. Profit margin is hardly ever given much attention. because…
Venture capitalists invest in businesses and depart when the market value rises.
You must have understood by now that the early investment need a very good exit. In order for them to depart, the company’s worth must rise.
Coming Back to the Story
The $5 million we raised will be used to increase income. To do this, we will expand into new countries, provide attractive discounts, and engage in marketing efforts. Using this 5 million, our Skyhorn company’s revenue increases to 20 million dollars.
Our firm is now worth 20 X 10 = 200 million dollars. Previously, the worth of our firm was just $50 million; currently, it has immediately reached $200 million due to a fourfold rise in market revenue.
Jior Ventures purchased a 10% investment in our firm for $5 million, increasing its worth to $20 million. Jior Venture is making a 15 million profit without doing anything.
Series B & Series C
To help the firm develop even further, me, you, and Jior Venture are planning a new fundraising round. Fosmos Venture will be approached and asked to participate in our Series B fundraising round. Fosmos will participate in our firm because when we complete our next Series C investment round, the valuation will be greater than $200 million, and Fosmos venture will profit by performing some stake selling. After some time, when Skyhorn’s worth has increased further, the Fosmos venture will sell the remaining portion.
As a result, the startup valuation bubble will be exposed in all future investment rounds. These bubble founders and venture investors work together. An IPO to be listed on the stock market represents this whole value bubble. Retail investors invest to profit from listing gains as soon as an IPO is available on the market. The money then flows to the entrepreneur and venture capitalist as soon as the company is listed on the market.
Trap
Why do retail investors participate in their IPO despite the fact that they have created so much bubble? When we invest money, the value of these equities plummets dramatically. You will be shocked to learn why this is so.
When a startup goes public, it uses a variety of methods. As a result, more and more individuals will invest in their IPO. Many others play a part in this as well:
- The Founder
- Broker
- Influencer
- Marketing
Before launching an IPO, Founder do marketing in front of us through various media. The founders do several interviews, podcasts, and display banners on the large screen. Get your articles published on a variety of social media platforms.
Brokers run several advertisements, such as those you’ve already seen on YouTube, as well as develop content and maintain a high-traffic website.
Marketing will achieve this in such a way that the firm name will appear in front of our eyes on a regular basis. Many things begin to happen as a result of this, and flowers of praise begins to fall.
They will simply say that the company is profitable and has expanded into many countries, therefore invest in it. If the company has expanded but is still losing money, no one will invest. All they think about is making money.
Locking Period
At the time of the IPO, there is a 6- to 18-month locking period for founders and venture capitalists, during which they cannot sell their shares. In many situations, the share price has already begun to plummet before the announcement. How does this work…
Every fundraising round, venture capitalists come in to grow the bubble; similarly, when the IPO is published, retail investors want to expand the bubble. The retail investor profits and has fun as a result of this.
Numerous investors invest in the IPO of several loss-making companies just for the listing benefit. However, listing gain is not always possible. If they receive a listing gain, they will book a profit; if they receive a listing loss, they will sell shares in order to limit their loss.
Many IPOs of such majority companies begin to collapse as soon as they are listed on the stock exchange. As a result of the selling pressure, the company’s stock price begins to decrease constantly in a short period of time. When the founder’s and venture capitalist’s lockup period expires, the value of the shares has fallen so low that it is difficult for the founder and venture capitalist to profit.
This is why, prior to the IPO’s listing, stakeholders have already made money through significant stake liquidation.
These Players are Quite Smart…
People sell the stock before the lockup period expires because the firm is losing money. These clever people are now thinking how they may use financial engineering to transform a losing startup into a profitable one. People will think that because the company is now successful, the stock price will rise in the future, thus they will not sell the shares and will retain it for a longer period of time.
These smart investors sell their equities as soon as the lockup period ends. This is the actual loss of retail investors like us.
It is crucial to understand the hidden reality behind each IPO that enters the market.
Track the balance sheet, why is the firm launching the IPO, what will the company do with the IPO money. Intangible assets are sometimes used by businesses to make their balance sheets appear more strong.
Next time whenever you think about any IPO then please consider the things I explained in this article. I just hope my article will become helpful to all of the readers.
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Disclaimer
This is not a Financial Advice. This article is meant only for educational purpose. I am just sharing my thoughts and analysis based on my many years of experience.