When Is A Lower Valuation Better? A Conversation With An Entrepreneur
The conversation started with Fred Wilson’s blog post, The Valuation Trap. He was riffing on a TechCrunch post about Square and Box.com which observes that high valuations for private companies fundamentally limit their strategic options. [Disclosure: New Atlantic Ventures in which I am a partner has an investment in CivicScience, Inc., which is mentioned below.]
The gist of Fred’s view:
“The moral of this story is that you can push valuations when you have investors knocking down your door, but unless you are cash flow positive and expect to remain so for the foreseeable future, you do that at your own risk. You will need to find someone to top that price down the road and that person may not be there.”
Finding this a wise perspective, I passed the post along to my partners and start-up CEOs that I know. John Dick, the CEO of CivicScience, Inc., pushed back strongly:
“This is brilliant. Next time we have competing term sheets I will be sure to lobby our board and shareholders to take the lower valuation so we can hedge against future failure. I’m sure that will go over well. ☺
Yes there are potential risks … But practically speaking, it’s a fairly absurd and categorically self-serving point of view.”
CEOs sell stock and investors buy stock (although they usually own stock already, too). So an investor arguing for a lower valuation can be self-serving. But that does not make him or her wrong. I replied:
“I’m more sympathetic to Fred’s view, mostly because of the momentum dynamics of valuation: what’s going up tends to keep going up, and when it turns down it often turns down sharply.”
To which John replied:
“I completely understand the momentum dynamics. I just can’t ever see a company saying to an investor: ‘While I appreciate your generous valuation offer, we think it would best for the company long-term if we reduce that number by 20%.’ It just doesn’t seem practical.”
Clearly there is no right answer here. The important thing is to understand the dynamics and weigh the risks. A strong and rising valuation is a holy grail for a start-up: it signals success to all the interested parties and allows the entrepreneurs to retain more of the value they have created.
However, like most good things, too high a valuation too soon can be a bad thing. And from the above you get a sense of how strongly CEOs and incumbent investors can drive for higher valuation.
Companies don’t control the offers they receive, of course. New investors have the last word. But companies decide what expectations to signal, and signaling has significant effect on how new investors structure offers. I have seen investors walk away because the signaled expectations were too far from the price and terms they were prepared to offer. On the other hand, a company that signals confidence and an expectation that is slightly aggressive but basically realistic can lead a new investor to make a better first offer. It’s vital to get at least one offer and very important to get more than one. This is the strongest reason to keep expectations reasonable at the start.
Should they be so fortunate as to receive multiple offers, the board and investors need to weigh valuation, terms, and investor quality when they decide how to negotiate and which offer to accept. Multiple offers are the best way to move the discussion to market price and push out onerous terms. I like to say that two offers are way more than twice as good as one. Even with this leverage, it makes sense to be moderate, for the reasons Fred Wilson lays out. I always keep this bit of Wall Street wisdom in mind: “Bulls make money, and bears make money, but pigs get slaughtered.”
In the fevered atmosphere that a high-stakes financing can create, the CEO, investors, and non-investor board members need to keep a long term perspective and balance risk and ambition as they signal expectations and negotiate price and terms. Price is always near the top of the list of considerations, but the highest price is not always the best offer.
Originally published at www.forbes.com on May 11, 2014.