Your Valuation is Too Damn High
Yes, it is possible to raise money at too high a valuation.
As a founder, it makes sense that you want to complete a fundraising round without giving up more equity than you absolutely have to. The natural thought process is to raise money at the highest valuation possible. If you’re planning to run your business forever, a high valuation is a good thing. But if you’re like most startup founders, a high valuation can be a big problem down the road.
Most tech startup founders are looking for an exit. The most common exit for these types of companies is being acquired by a big player in your industry. Raising money at an extravagant valuation can prevent you from taking an exit that you otherwise should take.
Let’s say you, the founder, get an offer to sell your company for $20M. Maybe you own 10% of the shares of the company. Your cut of the deal will be $2M (maybe less if you have a liquidation preference). You’re a first time founder, and this $2M would significantly change your life. You decide this offer is in the best interest of you and the other shareholders, and you decide to take the deal.
If you previously raised money at a $5 valuation, your investors would likely be happy with the deal. Depending on the terms of your investment, they could see a return between 4-5X. Most funds would consider this a decent exit.
However, let’s say you raised money at a $15M valuation. Now your investors are seeing a 1-1.5X return (or worse). While that $2M may be life changing for you, your investors may decide a 1.5X return isn’t worth their time, and they’d prefer to continue growing the company and looking for a bigger exit.
If you think you can continue growing the company successfully, that’s great. But if you, the guy who does the day-to-day management of the company, decide that the $20M you’ve been offered is likely to be a better return than you’d get if you continued to grow the company, you’re stuck. Having raised money at a higher valuation has now prevented you from taking an exit you believe is in the company’s best interest.
The situation can get even uglier if the acquisition offer is below the valuation at which you raised money. Things like anti-dilution protection can mean that the founders get much, much less out of an exit than they would have if their initial valuations were more reasonable.
This doesn’t even take into account the effects that valuation have on your potential acquirer pool. Most established companies could do a $2M acquisition if they really wanted to. Some of those companies couldn’t afford a $20M acquisition, and even fewer can afford a $200M deal. If you’re raising money at a $200M valuation, you’re probably doing OK and don’t need my advice. But for companies looking to raise money at valuations of $5M — $25M, you should seriously consider how doubling your valuation will impact the likelihood of another company acquiring you.
Reasonable valuations help you, your management team, and your investors make decisions based on what’s best for the company, and not based on previous valuations.
