Be Careful What You Wish For

The other day I was having coffee with a former intern of ours who had gone on to quickly becoming the CMO for an up and coming augmented reality start up that was starting to get some nice traction.

Its only natural that the founders who are building their first startup and so really haven’t gone through the entire fundraising cycle of a startup before would want to raise capital at the highest price possible both to limit their personal dilution and to feel good about themselves and what they had accomplished so far. And so they did. They convinced a well known corporate VC to price a $3mm round at $30mm post earlier this year and they will need to raise their next round by the middle of next year. My former intern asked me what I thought the odds would be of a successful raise. Unfortunately, at the current revenue run rate, I had to tell her that I was not that optimistic because by placing such a high post money value on the prior round, they had also placed a roadblock to attracting VC’s to the next round.

The reason is that the VC industry is a collegial one. We live in a very symbiotic ecosystem in which we share both deals and information up and down the food chain. We work hard to build strong relationships amongst each other so that fellow VCs will refer deals to us and the deals we refer to them are taken seriously. This enables access and risk sharing amongst us in the form of syndicates. Does that term sound familiar? It should. The Mafia uses it as well.

The dynamic this creates is that VCs trying to maintain the favor of their brethren don’t like calling the portfolio companies their fellow VCs ugly (read overvalued). They want to price the round being referred by the VCs who invested in the last round at a price higher than the last round vs. leading a “down round” and causing a lot of angst. For this reason, many VCs just prefer to pass on the round and avoid the conflict and bad feelings inherent in down round. This is very common behavior and it will significantly limit or even bring to zero the universe of VCs who will invest in your company.

This is what I mean by “be careful what you wish for.” High post money valuations are a sugar high. They feel great at the time they happen, but can sow the seeds of a company’s demise. You always hear that creating an inspiring vision is the primary value add of a CEO and that is certainly a truism, but right next to it is not running out of money because who cares about an inspiring vision if the team doesn’t have the capital necessary to execute against it. Its just a idea at that point, not a thriving company. So if job number one is providing the capital to execute on that vision, its important to understand the VC ecosystem and how it operates. Maximizing the value of any particular round is not the goal, making sure the company always has enough capital is because the only valuation that really matters is the one at the time of exit. All the others until that day are mirages in the desert.