More Money, More Problems: The Down Side of a Mega Valuation
Entrepreneurs fight for that big first valuation just like job seekers fight for the biggest salary--figuring the more they get now, the bigger the payday will be down the road. It's inherent to the hustle. This fight over ownership and control pits entrepreneur against investor the minute talk of a company's valuation begins. The investor wants a bigger percentage of the company via a lower valuation; the entrepreneur wants the opposite. But why the hostility? The reality is that both parties could learn a bit from the smaller-piece-of-a-bigger-pie analogy. Here's why.
It's a tough way to start a wedding. Investment partnerships are pretty darn hard to break up. As such, starting your journey together after a big valuation fistfight is not wise. Investors are folks who are going to be at your side, formally and informally, for a long time. Entrepreneurs should realize that they're competing for their investors' attention and money, vying against both new opportunities and investments already in the VC's portfolio.
The last thing a founder wants is to push hard for a high valuation at the start, only to have the investors write the company off down the road because they don't have much to gain anymore.
Down rounds are bad. Too big a valuation at the starting line can set expectations too high for future rounds of capital. Unfortunately, the VC world doesn't do well with this type of correction. Going from a $10 million Series A round to an $8 million Series B round carries a stigma--namely that your team or idea was overvalued. Making matters worse, it's not the investors who usually suffer in a down round, it's the founders, who often have to give up a much larger portion of equity to secure that round and keep the lights on.
Up rounds can go only so high. Investors are always doing math, and as company valuations get increasingly high, the calculations get tougher. If the going acquisition price for a company in your industry is, say, $100 million, your investors are going to work backward from that to arrive at the maximum valuation they can stomach. If they hope to make 10 times their investment, they'll be hesitant to get involved in an initial valuation north of $10 million.
Everyone recognizes early-stage valuations as an imprecise science, but they also realize that over time, a company's value trends toward what it's actually worth. In my job as an investor, I try to set the valuation bar a little lower at the beginning and make it up to the founders in other areas: option pools, preferred returns or performance compensation, to name a few. This way everyone wins--except for maybe the founder's ego, as he or she won't get to enjoy bragging rights and buzz over a big valuation number. Instead, the founder will have to make do with a vastly improved chance for success.