Size Matters — Just Not in the Way You Think It Does
Media outlets, fueled by company press releases, love to write about private company valuations. There is a running list of “unicorns”, private companies valued at over $1 billion, which is updated regularly. (At last check there were 95 companies that achieved unicorns status this year through October 2019). The press also loves to highlight large fundraising rounds. Many newsletters covering start-ups, such as Strictly VC, organize their daily fundraising notices by the size of the round raised, with the company announcing the largest amount raised listed at the top.
The conventional wisdom is that companies that raise large rounds (at large valuations) are “hot”. While it may be fair to categorize these companies as “hot” (from the standpoint of the supply/demand of investor capital), the implication that the business model is sound, the company will be successful, and that it’s a great place to work — “you too will make money, just like the investors!” — isn’t all that fair to presume.
Actually, when evaluating companies, particularly for full-time job opportunities (with the hope of financial upside from the increase in the value of your option grants), large amounts of money raised and high valuations are, more often than not, a negative signal. Those joining companies with high valuations (particularly at VP and higher levels where equity option grants can be a large element of the total compensation package) should be wary for a variety of reasons.
First, the reported valuation may be misleading to common shareholders. The reporters who write about valuations rarely have insights into the detailed terms governing an investment. Such terms can include special “protective provisions” for venture capital investors buying preferred stock, protections that other common shareholders and option holders don’t receive. These include minimum liquidation preferences (meaning preferred shareholders get a multiple of their investment back first before other shareholders get any value) and/or participation features (meaning preferred shareholders get their money back first and then also participate as common shareholders). Offering these protective provisions to new investors allows companies to raise funds at a higher valuation than otherwise possible, appearing more “successful” than they truly are.
Second, a substantial “up round” (increase in company valuation in this round compared with the last capital raise) typically leads to a significant increase in the 409A valuation. The 409A valuation (required at least annually by the IRS) is a valuation of the common stock of a private company. Boards used this valuation to set the strike price of all options granted after each 409A valuation date. An increase in the option strike price reduces the potential increase in value for grant recipients (and would require a higher cash outlay in the future to exercise these options).
Third, high valuations imply that investors believe in a sizable continued growth rate for the business, which is eventually converted into cash flow. An investment at a high valuation is, in essence, a payment made today (to the company) for expected future returns (from future cash flows generated by the business). The higher the valuation the greater the “bet” placed on future performance. In turn, this increases pressure on the leadership team to perform and encourages higher risk behavior. And, any miss against the aggressive plan (that justified the high valuation at which the investment was made) usually substantially reduces the valuation assigned to the business in the future. This is why in the public markets you see a company narrowly miss their earnings expectations or even beat expectations but guide towards lower future growth and suffer a sizable decline in their stock price. Joining a highly valued business means you take extra risks — you may work really hard, deliver great results (albeit below prior expectations) and then see only minimal increase in the value of your equity or options after multiple years of work.
Businesses that create substantial equity value usually do so because they are capital efficient. Raising sizable rounds signals the opposite of capital efficiency — perhaps the business is capital intensive or requires a lot of overhead to scale, or customer acquisition and retention are expensive and challenging.
So, what is the alternative if you are seeking the benefits of a venture-backed start-up (working on an innovative product in a high growth environment) and seeking to generate meaningful equity upside from your options or shares?
Seek out businesses that have reasonable traction (customer and revenue growth) without raising a lot of money. Amidst all the animal analogies being applied to businesses, I’d like to propose a new term for this capital-efficient company — a snow leopard — rare and hard to spot (inspired in part by this advertising campaign).
If you are seeking to build personal wealth through your employee equity, look for the lesser-known names that have raised less capital and, ideally, at lower valuations. Often these companies are located where the venture capital community has made fewer inroads. And, typically, these are companies targeting smaller but still sizable market opportunities. Get to know these businesses and consider working there. Capital efficient traction implies there is something really interesting happening. Your odds for financial success increase when working at these types of companies.
As for the high flyers who are well capitalized and sport large valuations — those are great companies to sell your consulting services or product/software to.
