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For any startup financing to be successful, the startup company and the investors need to be on the same page about a lot of issues. This is because, in the absence of this understanding, valuation divergence can be a quagmire of ever-escalating tensions between the two parties. One major source of conflict between these two parties is the fact that sometimes the rate of growth at which the company is growing and the rate at which the investment of the investor is growing can vary from each other. This phenomenon is called valuation divergence. Most seasoned investors are aware of this phenomenon and it would be advisable for entrepreneurs to be well versed with it as well. This article will explain the details of valuation divergence as well as its root cause.
When investors invest in a startup company, they expect the value of their shares to increase rapidly over the years. This is on account of the high risk that they take by investing in a company that does not have a proven successful business model.
Investors expect that there will be a high degree of correlation between the growth in the valuation of the company and the growth of the value of their shares. However, often this is not the case. It is possible for the valuation of the firm to grow from $10 million to $100 million i.e. a 10× return. However, at the same time, the value of investors’ shares may only grow from $1 million to $3 million i.e. a 3× return.
From the above example, we can see that it is possible to have a disparity in the rate at which valuation is increasing for the company as well as for the investors. It is even possible for investor shares to lose value while the value of the overall firm increases simultaneously. This phenomenon is called valuation divergence.
Novice entrepreneurs and investors do not often know the cause of valuation divergence. Valuation divergence is the result of a steady dilution in the equity stake of the investors. A dilution in equity stakes happens because of subsequent investment rounds in which a company participates in. This is because when an investor first invests in the project, they may hold a bigger percentage of the total shares outstanding.
Let’s say that after the investment was made, investors held 30% of the shares of the company. However, as further investments were made by other investors, the company issued more and more shares. Hence, it is possible that at the time of exit, the investor may hold only 10% of the shares of the company. This is the reason that the value of the shares held by investors does not grow at the same pace as the overall company.
Some novice founders and entrepreneurs are of the opinion that valuation divergence will not impact their company. This is because they feel that they have raised all the money which is required for the business to survive and thrive in the next few years. However, an empirical analysis of data proves that this claim can be quite misleading. Most startup companies lose money in the first few years of existence and almost none are able to thrive with just a single round of funding.
Also, if the founder has raised all the money at the seed stage, they have sold their company out for very cheap. The valuation of a company typically increases with the passage of time. From a founder’s point of view, it would not make much sense to raise all the money at the earlier stages when the valuation offered will be abysmally low.
Hence, it would be prudent to assume that further rounds of funding will be required and that some amount of divergence will be there.
Understanding valuation divergence is important for entrepreneurs and investors since it is one of the factors that need to be taken into account while discussing the overall valuation of the firm. Both investors, as well as founders, need to take into account that some amount of divergence will be there when they decide on the valuation of the firm. If they fail to consider this factor, one of the parties may not be happy with the outcome a few years later. This will lead to constant strife between the partners and may negatively impact the growth of the firm.
It also needs to be understood that theoretically, it may be possible for the investor to prevent valuation divergence. They can include stipulations in the funding arrangement which make it mandatory to issue proportionate shares to the investor at no cost to prevent any dilution from taking place.
However, in real life, most founders will view these clauses as being predatory. Very few founders will agree to these terms. The ones who will agree may probably do so temporarily and may try to terminate the agreement at the earliest.
Hence, the bottom line is that the investors, as well as founders, should consider valuation divergence to be an integral and unavoidable part of startup funding. Hence, instead of preventing it, they must budget for divergence while making the investment.
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