What is described here is not just an unrealistic valuation, it is fraudulent.
Here is how it works:
- A private company raises money from private investors, who (for example) purchase 15% of the company for $10 million, giving it a valuation of ($10M/.15=) $66 million dollars. (Remember, this is the private investor setting this value.
- The company invests in office space, hiring people, etc, and burns through money, and so needs more money.
- The same private investors invest $25million this time, the burn rate has increased, but they only get 5% of the company,giving a valuation of (25M/.05) = $500 million dollars.
- Rinse, lather, repeat.
Analysts go crazy, and it goes public, and the investors pocket a $9.9 billion dollar profit off of a $100 million investment, a 9900% profit margin.
Even if this shell game fails 9 times out of 10, you still have a 1000% profit margin, and someone else is left holding the bag.
You just need enough money to flood whatever market sector the company is in, and keep the balls in the air until you sell your stake.
This is Uber, Lyft, WeWork, Blue Apron, etc.
A feature in startup investing called a liquidation preference also often gives the latest investor their money back plus a return before others, meaning the newest valuation often only applies to that investor. These preferences usually disappear after a company goes public. Pre-IPO valuations of unicorns are on average 48% higher than their fair value, according to a recent study by two professors at the University of British Columbia and Stanford University.These are not, "Valuation illusions," this is fraud, pure and simple.
WeWork has had a sobering effect. But there’s a lot of capital to be deployed and hot startups can still make investors compete to give them cash. There will be more valuation illusions before reality sets in.
The goal is not to invest in a profitable company, it is to foist it all off on the next chump.