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BTDT: How a high valuation could actually run your business into the ground

In my first #BeenThere post I gave you a real time look at the most difficult decision I’ve had to make as a Startup CEO. I shared it while it was very fresh — so much so that we were still experiencing the aftershocks as a team. The response was intense. Many of you reached out with similar stories and I thank you all for the empathy. Some found it a bit controversial for me to share — and to do so in real time — but I made a commitment and I’m sticking to it.

Today, I want to discuss one of the topics that I’m ALWAYS asked about when I talk to new founders or people thinking about starting a business — the magic (or lack thereof) behind setting valuations for early stage companies. Since I have #BeenThere a few times, I figured it’s a good place to start.

Be careful what you hope for.

Pre-money valuation. This is the “magic” number that everyone hypes. It’s the number we are led to believe validates the existence of early stage ventures but how it’s calculated remains a mystery to most.

Unfortunately, there’s no single formula. I can’t give you a process and say go for it. What I can do is arm you with the most important insight I’ve absorbed along the way…

Valuation does not equate to value (or validation for that matter!) 

Like most of you, I had been conditioned to believe the higher the valuation, the better.

As a founder trying to raise capital, your default thought is to drive as high a valuation as possible, thereby minimizing dilution. It seems obvious — on the financial front, the more money you can bring in at the lowest possible dilution leaves you in the best possible position with both burn rate (money in the bank) and high percentage ownership in your enterprise. On the emotional front, the more “headline-worthy” the valuation, the more secure we feel about our place in the market and our ability to succeed.

The media validates this way of thinking every time they put a spotlight on an inflated valuation. We’re surrounded by headlines about how so and so mobile-social-local app raised $zillions at a staggering $bazillion valuation. As a result, we assume that at such a major valuation, the business is destined for market domination.

Competitive buyout valuations don’t help the situation either. We consistently see companies like Google and Facebook buying companies for what seem like stratospheric — even asinine — values and our perception continues to be distorted as a result.

While it took me a while to recognize it, what you MUST know is this:

The buyouts you read about are inflated. In reality, they are completely unrelated to the valuation of the product and/or service itself.

When it comes to competitive buyout valuations, the sale price is very rarely influenced by the actual value of the business. Generally, these acquisitions are executed to prevent disruption in multi billion dollar revenue streams. Not exactly the type of math that applies to more common ventures — making the numbers behind these buyouts irrelevant. Separate them from your own expectations.

Let’s take a look at what it means when an early stage company has raised a venture round at a very high valuation:

From the investor’s perspective:

A few VCs/Angels were willing to bet long on the business and were comfortable taking a small percentage of the business in exchange for the right to invest in the future IF the company starts exploding with growth. In most cases, the investment makes up only a very small portion of their overall portfolio. And they do this many, many times over. The idea is that they get in early and secure the right to play later should the company become one of the very, very few that blow up.

From the early-stage founder’s perspective:

The founder was able to retain a big percentage of his/her business and get a bunch of money with which to operate the business.

Seems like a good trade off, right?

It’s not — and here’s why:

Let’s assume this isn’t the last round of funding the company is going to need — which is almost always the case. What the valuation REALLY means is that the founder just set a crazy high bar for the business to reach before being able to raise more funds.

As a result, the race is now on to make that business worth a bunch more than the post valuation of the previous round. Talk about pressure! If the company isn’t ‘blowing up,’ when the founder goes out to raise more money and the original VCs/Angels who invested don’t lead or participate in the new round, that sends an incredibly bad signal to other potential new investors.

I’ve said this before, but one of the best days in a founder’s life is the day they raise their first venture round. One of the scariest days of a founder’s life is the day AFTER they raise their first venture round. It’s like “Tick Tock the Crocodile” is following you around everywhere you go. The countdown to success or failure has begun.

Building a business is hard. Period. Now add the pressure of having to live up to a very high valuation and having to produce results powerful enough to prove you deserve an even higher valuation for your next round.

That’s like scaling Everest alone… in a bikini.

And in the very real and highly probable case that you don’t grow your business at a crazy high rate — and you’re not able to summit Everest prior to running out of money — you’ve set your business up for what’s called a ‘down round.’ In a down round, when you raise money you’ll receive an investment at a valuation lower than the post valuation of your previous round.

Ask any founder that’s gone through a down round (myself included) and they will tell you, without exception, that very bad things happen.

Down rounds are sometimes necessary to keep a business going, but the only person who’s happy is the new investor who has just received inexpensive ownership while crushing down the equity of everyone already involved; including the founders and key executives.

All of this assumes you can even get a VC to fund a down round and I can tell you, more often than not, you won’t.

So how do I think about valuations now?  

I look into the future… at the implications of a valuation. Instead of how big, I think about what’s right.

I think about the following things:

– What is the right valuation so that over the course of the time I can operate my business on the funds being raised?

– What value do I think I can build with the business?

– What do I think the business could be worth – realistically – over the course of the next 18-24 months of operation?

If you don’t think you can build value greater than the valuation you’re locked into after negotiating your current round, you’re setting yourself up for failure.

Here’s how it played out for me.

When we raised our last round at PivotDesk, we made good progress from the first round. I (and most investors) certainly would not call it world-domination type progress — you know, like you read about — but it was realistic. My lead investor and I had a very real conversation about what the company “should” look like in 18 months. The conversation consisted of the following:

– What is industry data?

– What is our expected growth rate?

– What is the cut off point between early stage and growth investors for valuations?

These are all important issues to consider. They answer the question, “What is the right valuation for my business?”

 Here are two examples of what it might look like if you follow this approach:

Valuations (1)

And here’s the logic behind each:

Example #1:

– Entrepreneur raises a Seed round and gives up 20% of the company to capitalize his/her business with $500k of outside funding.

– The seed syndicate and CEO agree on a $2M pre-money valuation which implied $2.5M post-money.

– The seed money gave the company the opportunity to work on their product and start to build momentum but they sought venture capital to extend the runway.

– The venture firm recognized the progress from the Seed round and agreed to a $3.5M pre-money valuation all the while investing $2M.

– Assuming a simple $1 per share price for the Seed round, there is a jump in value from Seed to Series A of 40%.

– The Common Stock gets diluted down to ~51% but that’s still $2.8M of a $5.5M pie (not taking into account liquidation preference for simplicity).  

Example #2:

– Entrepreneur fights tooth and nail for a high valuation of $3.5M pre-money for the Seed Round while raising the same amount of money ($500k).  (and potentially passes up the right investment partner in favor of a partner offering the higher valuation)

– Momentum is ok when they seek more funding but VC firms tell them no to anything higher than $4M.

– Ouch – post money from the Seed round is now exactly the same as pre-money for the Series A.  (A ‘flat’ round)

– The seed syndicate could invest more money to avoid dilution (exercise right to participate pro-rata) but now they will have to commit to more money with no real value creation.  (read: unhappy people)

– The entrepreneur owns more of the company than in Example 1 but likely has to deal with unhappy seed investors and reputation issues that might come with that.

– Is fighting for $700k (difference in value between Examples 2 and 1) worth it in the early stages of a company when ultimately the goal is to own a decent piece of a very large pie?

And remember, if the pre-money valuation was even higher and the founder had trouble getting investors to stretch for a $4m pre, then the Series A might not even happen. Business dead.

(No, I’m not the expert here — I’m just sharing what I’ve learned through experience. For more information on the definition and math behind valuations, please read “Venture Deals” by Jason Mendelson and Brad Feld).

“A slice of a watermelon is a lot better than an entire grape.” [tweet this]

If you are raising venture funding, you will take dilution as a founder. But its your #1 job to make sure your company is capitalized sufficiently to succeed. You need the resources to hire the best people, reach the right markets, have leeway for mistakes or pivots, and all the other unplanned things you deal with six times a day.

That means that after the several rounds of funding that most companies go through, upon exit, most founders retain somewhere between 5 and 15 percent ownership in the business. Yes, you read that correctly.

Other people will almost always get the majority of the money in the event of a sale after several funding rounds. Very few people will tell you this, but that’s the reality. That’s why VCs back companies that have the potential to become $B companies. Owning 5 percent of a $B company is worth a lot more than owning 100 percent of nothing.

Are your eyes bigger than your stomach?

Think about an early stage valuation like an Ice Cream Sundae: The bigger they are, the more enticing they look to everyone at the table. But at some point, you’re the one who ends up vomiting in the bathroom instead of sitting back, patting your belly with satisfaction.

Remember, no one succeeds on a hype-based framework. Employing a reality-based framework when it comes to valuation is vital.

Now go build a great company.

And if you have extra space in your office, please consider posting it on PivotDesk to help out other great companies that need a place for now. You never know how much value you might get in return.

 

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