Your Startup is Overvalued

VC is a funny business. No other form of investing would tolerate the failure rate that is accepted in VC where (if you’re lucky) 1 out 10 investments is a home run, perhaps 3 return capital and the rest more or less fail.

Given this dynamic, it’s all about finding and/ or creating these home runs. Nothing else matters to be honest.

Similarly, there is no other business where unproven founders can raise so much capital so quickly. With no prior track record. It’s been proven again and again, that innovation can come from anywhere. And some of the biggest outcomes are from first time founders.

If you’re one of those outliers, everything is as it should be. Your valuation as a private company has no limits. Your access to capital has (seemingly) no limits. If you’re in the 90%+ of startups that are not outliers, then you’re actually entering into a mutual illusion regarding your valuation.

You and your investors need to pretend that you’re worth more. It’s a given, especially at the early stages, that VCs need to value your business at more than it’s truly worth. If they didn’t then fundraising would be basically like an episode of Shark Tank, where you would give away a huge chunk of your company for a small amount of cash.

The whole innovation cycle would fall apart if this happened. While it may be cheaper than ever to start a company, it is as expensive as ever (or more so) to build a market leader. So, VCs pretend you’re worth more than you are so that you can have your shot at building the next outlier.

This chart is an illustration of the gap that exists between how VCs value you and how a buyer would likely value you at each round. At the seed stage, you’re just not worth much. I know YC has told everyone that seed stage companies should be worth $9M pre, but that’s just a load of BS. If your startup fails to raise a series A and needs to find a home, no buyer is paying $9M or anything close to it.

As you raise more rounds, the gap starts to diminish. This is because valuation will become based more on actual performance vs. potential. By the time you get to a series C round you will be valued on your financial performance. In other words, investors and buyers will think about your business in similar ways.

Of course there are many exceptions to this. But in general the point is that you will have rational VC valuations by the time you’re a late stage company.

The challenge is that few startups get this far.

Source: https://www.cbinsights.com/research/venture-capital-funnel-2/

As CBInsight’s venture funnel beautifully illustrates, out of 1,098 funded startups, 10 become those outliers that VCs are looking for. 57 of them (~5%) were worth > $100M. The vast majority failed or “exited” along the way.

The failures we can set aside. It’s clear. No one made money. But the early exits are worth discussing. Chances are high that your company will exit before unlocking a huge valuation. According to the CB Insights data, < 1/2 of seed funded companies raise an A round. Only 14% of those companies had an exit. The rest just die. It’s a similar pattern at each successive round.

Many times, the “exits” that we see celebrated online are fake exits. The VCs have preference stacks, so they get paid first. Outside of a retention carve out that the buyer sets aside for founders and staff, no one makes real money.

This is why I talk about “optionality” every day with our clients at SurePath. I want them to build big, valuable companies. But I want to make sure that every step of the way, they’re well positioned for a truly profitable exit.

Given these odds, what should you do? As always, it depends. If you have high ambitions, low down side and think you’re really on to something, then go for it. Good things take time.

Source: https://hoangluongsjsu.wordpress.com/2014/10/19/linkedin-profiles-how-to-use-them-how-to-market-yourself-how-to-network/

Social networks are a great example of this. They seem to grow really slowly and then just hit an inflection point. This takes time and funding both to wait for the inflection point and then keep up with the growth once you hit it.

For every Linkedin, there are 100 startups with far more modest outcomes. Just remember this when it comes time to raising capital. Each round raises the bar. Only 5% of exits are for > $100M. Even a $100M exit isn’t that meaningful for a large venture fund. And if you have raised a lot of capital to get there, then it might not be that financially meaningful for you either.

The Linkedin growth graph is a great illustration of how you should think about funding. Be super stingy early on. Bootstrap and hustle your way to get to a point where you find a flywheel to drive massive growth in your business. Only then should you back up the Brinks truck and raise meaningful capital.

If you’re tempted to set that discipline aside and raise more earlier just because you can, then just remember that your valuation isn’t real yet. Make sure you factor that into your decision making. Stay grounded and realistic while shooting for the moon!

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