The irrationality in startup valuations

Do money-losing businesses even deserve high valuations? Does innovation justify the valuation?

Since the Great Financial Crisis of 2008, the tech sector has become the main driver of the economy. With companies like Apple, Facebook, Amazon, Google, etc. adding immense value to the world, the US was able to get out of the recession and reach prosperous times.

Part of the rise of the tech sector includes this new philosophy that being unprofitable isn’t a shame. Startups can spend as much as they need to on expansion and once they finish expanding, they can start focusing on becoming profitable. Amazon was the company that inspired this new thinking as the public was taught that Amazon wasn’t profitable for most of its years. What many didn’t realize was that Amazon’s business profitable was already profitable since its early years, but through creative accounting and continued reinvestment, they’re able to show losses on paper.

How do I know that Amazon was profitable in its early days?

According to Vox, Amazon was free cash flow positive way before it was profitable. Free cash flow is how much the company makes overall, accounting for the amount of cash it gets from operations, investments, and from financing. Being free cash flow positive shows that the business isn’t burning cash.

Many startups in this bull market aren’t free cash positive and because of it, they continue to need to raise more capital in order to finance the cash burn. While many of the cash-burning startups do have great ideas, I sometimes wonder when they’ll make a profit as their losses accelerate.

When talking to various investors, many justify the technology as an excuse for continued cash burn. They believe that once they finish growing, then they can start focusing on becoming profitable. But that move will be risky as unsustainable growth can one day lead to the demise of that company.

As we continue living through the bull market and witnessing these money-losing startups garner higher and higher valuations while losing more and more money, let’s enjoy the perks that these startups give us and hope that these startups start making money.

And if many of them do collapse, we’ll look back at this time and realize how silly it was to give higher valuations for a business that couldn’t make money.