In December, I had breakfast with a very smart entrepreneur and investor who asked me the following question: “Are we entering an era in which the valuation of businesses will be lower than it has been in recent years?”
This is a great question; and I don’t know the answer. But I do know that, if we are shifting to an era of lower company valuation, the change has important ramifications for entrepreneurs.
For the past 25 years, the price/earnings ratio for the S&P 500 has averaged about 20.7. But during the 1970s, that ratio was below 10. So it’s not inconceivable that an era of high valuation of companies has ended, and a new era of lower valuation has begun.
Here are some ways that entrepreneurs will be affected if public companies are now going to be worth half of what they were worth in the previous era:
The most successful entrepreneurs often take their companies public; and the valuation of IPOs is related to the value of the overall public market. While a 50 percent reduction in the value of the S&P 500 doesn’t necessarily correspond to a 50 percent reduction in the value of IPOs, it almost certainly corresponds to some reduction in that value. So, if we are in an era of lower valuation of companies, when entrepreneurs take their companies public, the entrepreneurs and their investors will pocket less money.
If companies are worth less money when they go public, then entrepreneurs who try to sell their businesses to other companies will probably have to sell them at a lower price. Lower value in the IPO market means that buyers won’t have to pay as high a premium for companies when buying them.
If the price of companies that IPO or are acquired declines because we have entered an era of lower valuation, then investors in start-up companies – the venture capitalists and business angels – will be getting less money in return for selling their investments. To try to preserve the returns that they earn from financing private companies, these investors are likely to reduce the valuation of companies at the time they are asked to invest in them.
If investors in young companies lower the valuations of those companies when they invest in them, entrepreneurs will see getting outside equity as a less attractive way to finance their businesses than they have in the past. Some entrepreneurs will shift toward more bootstrapping, while others will turn to debt financing. Still others will see entrepreneurship as a less attractive activity than they previously thought and do something else.
The smaller amounts of money earned by entrepreneurs and their investors will probably lead the media to spend less time talking about entrepreneurship. As a result, people will probably think that entrepreneurship is less attractive than they do now, and fewer people will start high potential businesses designed to raise external equity and get acquired or go public.
Even those people who start more typical businesses will be affected by the lower valuations of public companies. While the earnings from running one’s own business won’t be affected by these valuations, the price people can get from selling their businesses will go down (when the price of public companies declines so does the price of private companies). This will make people more reluctant to sell their small businesses.
I’m sure that I’ve missed a bunch of effects that entering an era of lower valuation of companies will have on entrepreneurship. But the general point remains: entrepreneurs are going to be affected if we shift from the high prices we have paid for public companies in recent years to levels more consistent with historical averages. So entrepreneurs should think about the effect of this potential shift.
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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool’s Gold: The Truth Behind Angel Investing in America; Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By; Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures; Technology Strategy for Managers and Entrepreneurs; and From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company. Scott discusses the topic of this post in more detail in his book Fool’s Gold: The Truth Behind Angel Investing in America .
