How To Inflate The Price Of Your Startup Stock
Many people wonder how startups can sell their shares at such inflated prices when the companies are not yet demonstrating the ability to back up their valuations with profits. Facebook on the day of its IPO at one point rose to over $42/share, a massive over-valuation, for example. Following is an explanation how Facebook and other startups get away with this.
Facebook reached a $150 billion valuation on secondary markets before its IPO at a $100 billion valuation. We all know what happened next: the value sank to $50 billion within months. As of this writing, the value is still falling.
One reason for the over-valuation is the fact that since 1980, the yield on corporate debt has been falling. Rather than accepting the current low returns on bonds, investors, with visions of the start-up IPOs of yore, are willing to believe that being in on “the ground floor” as a stock holder will yield gravity-defying returns. In this mindset, both regular investors and venture capitalists tend to see what they want to see in terms of company value. How can potential be accurately monetized?
Psychologically, two emotions are on display in the case of over-valued startups: greed and fear. Greed can disable normal risk aversion with the glimmer of possible wealth. Fear manifests as fear of missing out on the “best investment” and jeopardizing one’s identity as a savvy investor, or even a “visionary” in some cases. These are powerful drives that can easily override due diligence.
The second reason for over-valuation is the fact that startups are allowing venture capitalists to invest in a special way that reduces their risk.
The startups allow venture capitalists to buy stock with special rights. They buy “preferred” shares rather than “common stock.” Preferred shares may guarantee the investor that when the owner wants to sell the stock, the company itself will buy it back at the price originally paid. This eliminates the risk of value loss. Even if the company declares bankruptcy, the preferred shareholders have a priority in getting repaid their investment.
In return for these benefits, venture capitalists pay more for the stock -- by acquiring a smaller percentage of the company with the same amount of money, giving startups inflated valuations. Such inflated valuations may give venture capitalists a slightly lower potential profit, but it’s worth it to many investors to have an investment with lower risk.
For the reasons above, venture capital money has been competing more and more over the mega-hyped startups, such as Facebook, Zynga, and Groupon. Other high-profile startups to watch include Airbnb, Dropbox, and Y Combinator. Competing investors drive startup valuations for such companies through the ceiling as they find themselves paying increased amounts for preferred shares.
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