A common temptation for founders is to raise money at the highest possible valuation. High valuations may help with employee recruitment and compensation, generate positive PR for a company, provide ammunition for M&A, and stoke founder egos. Unfortunately, too high a valuation can lead to a host of problems down the line. For example, for many of the unicorn companies, their ability to raise their next round has less to do with whether they are viable businesses, and more to do with the valuation at which they previously raised money. 1
Too high a valuation relative to the overall market can cause the following issues:
1. Follow on fundraises become hard. Investors typically expect a 2–3X increase in valuation with each round. At very high valuations (e.g., billions) this decreases to a 50%–100% markup with each round. Nonetheless, adding $1 billion in market cap is actually a lot of value creation (revenue, user growth, etc.). The higher the valuation, the harder it is to grow % market cap.
2. Investor mix may shift. At high valuations the time horizons of the investors who will become involved may shift. Many of the non-traditional late stage investors who have entered private equity venture markets have a short time horizon of 18 to 24 months, and they may push for liquidity or progress in ways that may not be aligned with a company’s ultimate goals.
3. Internal pressure to hit a target valuation causes bad behavior. This is a biggie which I will mention more below: The pressure a founder puts on herself with a high valuation may distort her behavior and cause her to lead her company down the wrong path.
4. Employee expectations. People who join the company due to the perceived value and upside of the stock will be upset if a down round occurs or the valuation does not grow in the next few years. This can also occur if the company valuation slides flat for three to four years while waiting to catch up to its valuation.
The above are all fundamentally issues of expectations. The higher your valuation, the higher the expectations. The worst manifestation of this is the pressure founders put on themselves when valuations are high.
When a founder has a multi-billion-dollar valuation two challenges arise: (1) the founder may push unsustainable growth at all costs to hit the valuation and (2) a lot of distractions arise that may not help the business (e.g., press, speaking opportunities, investments, etc.).
The pressure to increase revenue or growth at all costs to meet rising expectation valuations is where companies can often go wrong. For example, doubling down on money-losing customer acquisition in order to show growth may accelerate market share, but also flip your company from default alive to default dead.
This pressure to grow may be self-imposed by the entrepreneur, but more often than not it also comes at the board level. Later stage investors may aggressively push for growth, especially if the projections that the startup company used in its fundraising deck are not being met. Late-stage investors may not always understand the uncertain nature of a startup, even one on a high-growth trajectory.
As an entrepreneur raising a round you should ask yourself the following questions:
- Will the money I am raising get me to a healthy multiple on my last valuation? If not, should I take a lower valuation so that this multiplier may be more feasible?
- What milestones will this fundraise get me to? Will those milestones fundamentally change the perception of my company’s worth?
- What sorts of exits are possible for my company? Are there likely acquirers above the valuation I am raising at? Do I plan to go public? If not, is it wise to raise at this valuation? If so, will my IPO be at a higher valuation then my private market fundraising?