Even professional investors sometimes accept artificial valuations as the new truth and get swept away by Irrational Exuberance. Pixabay

In most cases, the price of a product is determined based on supply and demand, which is the basic premise of a free economy. But when it comes to the world of private investments, the pricing of companies is sometimes determined by factors that impact on it artificially, rather than by traditional principles of supply and demand.

Unfortunately, even professional investors sometimes accept artificial valuations as the new truth and get swept away by Irrational Exuberance, when what they should be doing is analyzing whether these valuations are based on real economic considerations or other interests that they should be discouraging. Based on recent patterns in the world of private investments, I have observed several factors that directly divert/tilt the real price of a fundraising company into an artificial one.

The first is the increasing participation of strategic investors as leaders in financing rounds. These are not the veteran corporate VCs who usually join a round as co-investors with a small check and without having priced the round themselves.

Rather large corporations have been recently seen making very large investments (several dozens of millions of dollars) in companies for two main reasons: Either they are interested in being closer to the company’s innovation so that they can understand the industry’s trends or use the innovation for their own products, and/or they are exploring the option of a potential acquisition in the future lowering their overall buying ticket price on the way — especially if they create a dependency on them. They are not particularly concerned with valuations, and for them it doesn’t really matter whether they pay a 10 to 15 percent premium (or even more).

The second is the increasing presence of huge VCs and growth funds. Specifically, billion-dollar funds have recently joined the game, with massive amounts of capital that needs to be deployed over a reasonable period. Insight Venture Partners, for example, invests from a $4.75 billion fund; Softbank raised a $100 billion fund and is on its way to raising a few hundred billion more, etc. Given their sizes, those funds are less valuation-sensitive and are eager to deploy their capital. They are also considered a high-value investor, thus companies are very happy to receive their financing.

Lastly, prior valuations set the minimum bar for future ones, and if the last round was done in the past two years, the bar is most likely high. Markets go through cycles that affect valuations and alter valuation multiples, depending on a company’s specific industry or market. So the circumstances that might have affected its valuation two to three years ago may not necessarily still apply today. For example, based on our own research at Viola Growth, we have seen a decline of 75 percent over the past two years in valuation multiples affecting the market of one of our portfolio companies. Other markets have suffered as well, though to a lesser degree.

A new investor looking to join an already funded company usually isn’t emotionally attached to the prior valuation so is guided by prudent financial considerations rather than an artificially inflated outward appearance, but if it’s an over-valued company whose founders are already in love with its existing valuation, they are often reluctant to do a down round, especially if the company has progressed since the last financing round. This leaves the potential new investor in a deadlock, which pushes the company to seek other financing alternatives.

Artificial valuations work for some companies (even until the expected exit) — and it can be tempting to follow suit and bask in the glory of an envious albeit misguided valuation. It’s usually risky, and savvy investors are aware of this, opting instead to be cautious and cling to benchmarks and industry comps valuations when determining what a company is worth. In some cases, a premium price may be attached to an excellent team or a company in a hyper-growth situation, but this is usually only done in unique cases.

Overpaying may be harmful not only to the investors who will find it difficult to achieve their targeted ROI but may also impact badly on the company itself. Many unicorns — which raise more and more capital at higher and higher valuations — are a great example of this, because if and when the time comes for their IPO, it’s highly likely that they may not be able to live up to their inflated valuation.

There are many other risks associated with inflated valuations. The best way to avoid them is to let the market determine a company’s real valuation based on valuations multiples methodology and through good old-fashioned competition. This is sustainable and defendable in any scenario and minimizes the chance that Irrational Exuberance will affect not only the company itself, but will create a snowball effect with many other implications.

It will be particularly interesting to see what happens to companies’ valuations in the near future. It remains to be seen whether those investors who stand against Irrational Exuberance will reap the benefits of their patience.

Natalie Refuah is a Partner at Viola Growth, an Israeli-based technology growth capital fund and part of Israel’s leading technology-oriented investment group with over $2.8 billion in assets under management.