Why Startups Should Take Lower Valuations

It’s not uncommon for startups to receive runaway valuations in today’s venture capital environment. Hot money streaming from all around the world are eager to find the next unicorn investment. First-time entrepreneurs, especially, are at the mercy of being lulled into a starry atmosphere studded with so much cash that they don’t know what to do with it all. And that’s a problem.

Follow the leader (foolishly).

Venture Capital Herd Mentality
FOMO — fear of missing out — has never been more acutely exhibited by a group of adults, unless you’re counting those eager-beaver college freshman who sign up for every club under the sun. Venture capitalists are among the worst offenders of herd mentality. Too often, a VC firm would initially turn down funding a startup, only to flip-flop back into investing once it hears another peer fund has poured some substantial cash into the venture.

Over-indexing on Signaling
The problem with this is two-fold. First, it demonstrates that VC firms actually do not know whether they are making a good investment or not. Think about it. It’s like a dating ritual. The girl or guy with a bunch of pursuers appears much more appealing, when in fact, she or he may not have much going for her or him to boot. On the other side, a great gal or guy might find her or himself all alone in the wind, simply because a few first dates didn’t go smoothly. Before long, there will be unfounded rumors that the person is a leper. Yikes.

The second problem is the issue with the snowballing valuation. In one sense, you might argue that the hot startup now has leverage and can pit various VCs against each other, thus garnering higher and higher valuations. This in turn brings more press coverage, which is arguably great exposure for attracting potential customers and business partners. Soon, your little startup is flush with operational cash and attention.

Outsized Valuations, Outsized Expectations
There is a fine line to walk, between marketing the living sh*t out of your startup and keeping it in line with reality. With great valuations, come great expectations.

I had heard someone say — You can never have too much cash. I disagree. You definitely can. Not only is it irresponsible to squander investors’ money, but taking too much funding can also be a sure fire way to sink your own startup quickly. I’ve always believed you take only what you need, no more no less. Have enough for a rainy day, but don’t spoil yourself with too much, or you might be left drowning in the resource for being a gluttonous fool.

Runaway valuations set you up on a trajectory that is wholly unrealistic. Each new bar for a milestone will suddenly become much more difficult to achieve. Press coverage has nowhere to go, except bigger and more sensational. Any news that doesn’t offer an order of magnitude’s worth of wow-factor, can be construed as negative. Expectations to onboard customers magnify and the mandate to show a sustainable monetization model mounts faster.

The black hole of cash.

There’s already a tremendous amount of stress on founders, but heaping even more public and investor pressure doesn’t actually help. Startup life cycles are extremely unpredictable. There will naturally be ups and downs, as is expected from confronting existing challenges, overcoming them, and facing new ones, ad infinitum. What over-funding does is it creates the illusion that this startup is a rocket or a “sure thing.”

But this couldn’t be farther from the truth. Before long, the huge valuations that your startup receives begins to backfire, setting you up for impossible measures, where every stumble that would have normally been viewed as acceptable and expected, now becomes another proverbial nail in the coffin of disappointment. With enough strikes, a down round might follow, effectively closing the lid on your whole shebang. Remember, VCs are teenagers who follow, rather than lead. Once one pursuer distances itself, so will the others. Your startup will quickly tumble from belle of the ball to the ugly step cousin with a bad dress code.

Just remember, the public delights in seeing a rocket shoot across the sky, as much as it enjoys the fireworks of a massive explosion. The world is a cruel and cold place. The same people who say that they want your startup to zip into the stratosphere could be (and often are) the same ones who backpedal shamelessly with “See… I told you so!” mentality.

Cash Maladies
Money doesn’t solve all of your problems. In fact, too much green brings ailments as it corrodes the bonds of discipline, frugality, and creativity: you stop using innovative guerrilla marketing tactics in favor of spamming hackneyed advertisements on billboards and Google ads; you begin to offer high salaries attracting “top talent” but actually end up recruiting mercenaries instead of passionate team mates who would have joined for the cause; you begin to pay your way to generate leads instead of learning how to sell, etc.

Impending cash-tastrophe.

I’m not demonizing cash. Used in the right way and in the right amount, dollars are the steroids you need to beef up and get your startup to the next level. But have you seen what steroidal abuse leads to? I won’t get into the details, but you can Google the images on your own time.

Learning to Lower Valuations
I would have liked to title this article “Learning to Take Proper Valuations”, but in this hyper-funding landscape, I thought it is simpler and just safer to tell you to take lower valuations period. Chances are, no matter what, you’ll likely be over valued (a little humility never hurt).

It’s much better to follow the age-old adage: Under promise, over deliver. Now, I’m not advocating that you over abuse this tactic, but my point is you should always temper expectations by factoring in some margin for failure. Hell, your whole startup could go under any moment, keep that in mind.

There’s no good rule of thumb here, no clever math formula to tell you if offered X valuation, then take X/n instead. As an entrepreneur, it is actually part of your job to know intrinsically, what you believe your company is worth. You can use external benchmarks and estimations as guidelines, but ultimately, it is your company and you should know the in’s and the out’s without being misled by the allure of stardom, ego, and fast cash. Over estimate yourself or your company and you’ll head down a path towards destruction.

In the past, I’ve found that the best path towards a “realistic” valuation is, ironically, by thinking about organic cashflow. Now, most valuations are calculated on some some multiple of revenue. But I think Warren Buffett said it best, “Revenue is vanity, profit is sanity. Cash is king!”

Some might argue that you need to benchmark on revenue because startup costs are normally outsized initially. Therefore, using profit or free cashflow as a guiding star might undervalue your startup. That’s a fair point, and if that’s what you’re faced with, then you need to model out what the business could look like in the long run, given a sustainable cost structure. Point being, you should likely come back to a free cashflow model anyway. Like I said, it’s not a science (though VC’s would have you believe otherwise). I predict the notion of funding unprofitable businesses in the long run will likely diminish.

Tell ’em Arnold!

Even for a small startup, you should have accurate and good accounting. It’s not hard to try to follow GAAP rules (privately) even if you’re not yet a public company; just look it up online or seek resources to help you. This sounds absurd initially, but trust me, it’s a good habit to start forming early. The reasons for doing this twofold:

  1. It creates discipline so that you can quickly identify where you’re in need of financial assistance. It also highlights quickly your top and bottom line. And helps with all the other standard concerns like burn rates, runway, etc. which derive from it.
  2. You should strive to operate like a publicly traded company even from the inception, because that should be a dream! (Even if you exit through private acquisition before going public). Hold your startup and yourself to a high standard to keep yourself accountable.

Talking Investors Down
Once you’ve figured out what you believe you’re startup is worth (and acknowledged the hard truth that higher is not always better), you should try to learn to persuade investors to give you the amount of funding you want.

It’s you’re business. You need funding, naturally. But don’t be pressured into taking something that ends up being your Achilles heel later. It’s not a surprise that VC’s don’t always have your best interest at heart. The higher a valuation you have, the more an early investor can sell those shares to a later investor (assuming they don’t always want to participate in follow up rounds, which they don’t always do, but that’s a story for another day).

Part of the reason VC’s want to inflate your valuation is an ego and vanity play on their end as well. Nothing sounds better than having the genius to invest in another unicorn. Reputation begets reputation, even if a lot of it is hot air.

Another reason there’s so much hot cash is because VC’s need to answer to their own investors too (limited partners). And these LPs didn’t give cash to VC’s to let the dough sit while good startups are carefully investigated and identified as strong investments. The opportunity cost of not putting the capital to work is simply too high. Believe it or not, at many VC’s there are unspoken or understood rules that you had better put that capital to use quickly (with some X fund cycle). And this creates conflicts of interest because ultimately it can lead to brash injections of capital to totally bad startups without sufficient due diligence. Or, it could lead to massive cash injections to startups that become over valued post money.

Vet your VC’s as they should vet you.

Don’t Be Desperate
It’s hard to say this, but it’s even harder to do. When the chips are down, beggars can’t be choosers. Or can they? Remember that testing VC’s with your desired amount of funding (instead of theirs) is a great way to shake out the quality and temperament of investors. In China (where I have experience), at least, VC’s want to throw astronomical sums of money at you, with a heavy expectation for outsized gains within a scarily short time horizon. Is that the investor you want?

Your VC is not just a cash machine. It shouldn’t be. Good investors offer cash. Great investors offer much more in connections, sales leads, introductions to business partners, and even strategic advice. They should bring with them a strong portfolio of other startups that can be leveraged to potentially cross pollinate with yours down the road.

Being extended a term sheet isn’t always a godsend, and if it is, then make sure you choose the right god.