How can founders ensure an objective business valuation without personal bias?
As a founder, you must be extremely wary of inaccurate valuations since they can deter investors, set unrealistic growth expectations, and lead to suboptimal decisions in key areas such as mergers and acquisitions (M&As). A great example of this would be Yahoo! passing on Microsoft’s $44.6 billion acquisition offer and then, in 2016, having to accept Verizon’s acquisition offer for just $4.8 billion.
In Yahoo’s case, the valuation mistake may have occurred due to an overconfidence bias. At that time, Yahoo! was dueling with Google for supremacy in the search engine marketing space and their board may have mistakenly believed that they could match or even outpace Google with its existing market position and strategies.
To avoid such costly valuation mistakes, you must confront your biases. Hence, in this article, we will explore key cognitive biases that can distort startup valuations, including categorization bias, loss-aversion bias, confirmation bias, illusion of control, and recency bias.
5 behavioral biases that cause valuation mistakes
In the following sections, we will discuss some behavioral biases exhibited by founders that cause common mistakes in startup valuation. We will also discuss how to tackle these biases and improve accuracy.
Categorization bias
Currently, we are seeing artificial intelligence (AI) startups garner extremely high valuations in funding rounds. Many tech founders are considering pivoting toward becoming AI startups. However, founders must avoid the temptation to mislabel their ventures as AI startups since that would mean falling prey to categorization bias.
This bias is often found in tech startups. A classic example of this would be WeWork. The startup provided co-working spaces on rent, essentially operating as a commercial real estate firm. Despite this, Adam Neumann, its co-founder, marketed WeWork as a tech startup. The tech startup label was one of the factors that enabled WeWork to garner a peak valuation of $47 billion. Later, WeWork had to file for bankruptcy as its valuation dropped to just $45 million.
Loss-aversion bias
When a founder or investor has a loss-aversion bias, they will push back against down rounds. This bias strengthens when investors are anxious to make exits. As much as a startup’s valuation depends on its own performance, it is equally dependent on external factors such as industry trends, geopolitical situations, and macroeconomic conditions. This is an often-overlooked fact in situations where a startup receives a positive valuation in favorable conditions and capitalizes on its opportunities but later, must raise funds in unfavorable conditions.
Let us look at an example where founders successfully fended off the loss-aversion bias to secure funding.
Founded in 2012, Instacart is a startup that provides grocery delivery services. In the USA, most cities are designed with car travel in mind. In many areas, residents rely on their cars even for grocery shopping. This is a major challenge for people with busy schedules and people who do not own a car. Hence, Instacart’s service proved valuable and the startup reached a valuation of $17.7 billion in 2020.
However, in 2021, as the COVID-19 pandemic was being countered with lockdowns, Instacart attained a valuation of $39.9 billion. Two years later, when the need for lockdowns had subsided, Instacart’s valuation dropped to $10 billion in its IPO.
Confirmation bias
A founder with confirmation bias will look for evidence to support the valuation they believe their startup has achieved instead of calculating their valuation based on the evidence presented to them. Let us understand this with an example.
Suppose you believe that your startup is worth $350 million since that is the present value of its expected cash flows. At this point, if a larger corporation offered $400 million to acquire your startup, you might be tempted to go along with the deal. However, you must also check if your future cash flows are being capped due to your production capacity.
In such cases, your potential cash flow might be much higher. This would suggest that the trade practices, patents, and other intangible assets that you have developed are being undervalued. To correct this mistake, you must calculate the commercialization potential of your intangible assets and subtract the necessary capital expenditure.
The best way to deal with confirmation bias is to throw your previous valuation out of the window. Instead of trying to adjust the valuation based on the startup’s progress and changes in external factors, you should start the valuation exercise from scratch.
Illusion of control
Founders often develop an illusion of control as their startup overcomes hardships, scales up operations, and goes through multiple funding rounds. Since you face overwhelming odds as a startup founder, you need a lot of external factors to go your way to achieve success. When external factors consistently work in your favor, you may begin to assume this trend will continue indefinitely, or worse, believe you have some degree of control over these external forces.
To overcome the illusion of control, instead of estimating your valuation under just a single set of conditions, you must estimate your valuation in different scenarios. You can go over recently published research reports and expert opinions to identify the most likely scenarios for the economy as well as your industry. Then, you can take a weighted average of valuations from all possible scenarios to make a more balanced and realistic estimation.
A famous example of the illusion of control can be found in the housing bubble crisis of 2008. Prior to 2008, the general consensus was that borrowers would not want to risk their house being foreclosed on and hence will always try to keep up with mortgage payments. This led many institutional investors to take up huge positions in subprime mortgage bonds.
Such investors were caught off guard when the default rates spiked in subprime mortgage bonds and sent the financial markets tumbling down. In this case, investors made the mistake of assuming they could control or predict default rates.
Recency bias
This is a bias that may lead a founder to believe that their startup’s valuation has increased or decreased drastically due to technological advancements, favorable market conditions, or changes in customer preferences.
Instacart’s spike in valuation during the COVID-19 pandemic is an example of recency bias. In that funding round, investors and founders made valuation mistakes by assuming that the recent spikes in usage could be sustained post-pandemic.
Another example of recency bias would be the growth experienced by Snap Inc. in 2020. In that year, the social media company’s stock price more than tripled to $50.07 as advertising revenue grew on the back of soaring active users.
However, two years later, by the end of 2022, Snap Inc. was trading at $8.85. Investors who carried Snap Inc. to its peaks in 2020 and 2021 made the mistake of believing that the user growth and advertising revenue growth could be sustained.
Unlock your true value with Eqvista!
A startup founder may make valuation mistakes because of biases related to categorization, loss aversion, confirmation, illusion of control over external factors, and recency of information. You can tackle these personal biases and improve the accuracy of your valuations by disregarding previous valuations, analyzing multiple scenarios, balancing recent trends with historical data, and relying on unbiased expert opinions on external factors such as macroeconomic conditions and industry trends.
A well-researched, sound valuation is crucial for securing funding, maximizing returns from acquisitions, ensuring compliance with tax regulations, and maintaining strong investor relations.
Given its importance, this task is best entrusted to a valuation expert like Eqvista who can provide objective and reliable insights. In less than seven years since inception, we have valued over 19,000 companies for fundraising as well as tax compliance purposes. Contact us to know more!
