Dear SaaStr: Why is it dangerous to accept too high of a valuation from an investor for a startup company?
A lot of VC advice is a bit self-serving. There are risks with a too-high valuation — but also benefits:
A high valuation isn’t necessarily bad. It just has dangers. We’re seeing a ton of that now with unicorns that raised at very high revenue multiples that now are unfundable. But like many things, it’s nuanced.
A high valuation has five core advantages for founders:
- Less dilution. Not only does this mean you own more, but it also means you can sell more later for the same amount of dilution. This can help you “skip a round”. More on that here: The Pernicious Effect of Dilution in SaaS: The Cold, Hard, Bloody numbers | SaaStr; and/or
- More money for same dilution. This can be important. Let’s imagine you are OK selling 20% of your company in a round. If that round is at $5m post-money, you get $1m to invest. If that round is at $10m post-money, you get $2m to invest. That’s a lot more to invest. More on that here: Tier 1 VC is Great. But More Money May Be Even Better. | SaaStr
- Potential to raise a very, very long runway. Related to the prior point, but sometimes these days, you can raise enough capital to last 4-5+ years or longer. If you don’t spend it all, that can massively derisk things. If — you don’t spend it all and materially increase the burn rate.
- Secondary liquidity can get more attractive (at later stages). As your valuation goes up, VCs generally begin to offer “secondary liquidity” to founders, i.e. the ability to cash in some shares in a VC round. At a higher valuation, you end up not having to sell much of your position to generate some significant cash. This can also massively derisk things at a personal level. But secondary liquidity at a valuation much less than $100m often ends up being a bad deal in the end. Founders tend to regret it fairly quickly as things scale up.
- Signalling a winner / winner-to-be. There are so many startups today. Employees and others want signals of who’s a winner — and who isn’t. Fundraising isn’t the only signal, and it can be a false signal. But it’s a signal in any event. Most folks want to join a proven winner, or at least, a proven winner-to-be.
These are significant advantages of a higher valuation. Don’t let anyone tell you otherwise.
But a high valuation also comes with significant potential downsides:
- Potentially, a lot more pressure. A lot more. If you push an investor to pay more than she is comfortable with, that comes with a cost. Sky-high expectations. The expectation you will execute to perfection. Is that what you want? In extreme cases, it even sort of puts your job at risk as CEO. If you push your investors to the max on price, they’ll think a lot more about if you are the right CEO. A bit more here: How to Avoid Being Replaced as CEO by Your VCs | SaaStr
- Harder to raise the next round, potentially. Maybe even a lot harder. This is what a lot of VC advice focuses on. Each round really needs to be at least 2x the valuation, and price, of the last round to make the economics work (ideally higher). The higher the valuation, the higher the bar and burden next time. A bit more here: The 10x Rule: What Raising $1 of Venture Capital Really Means (the 2018 Edition) | SaaStr
- Harder to sell your company at certain valuations. This can absolutely be true. If you raise at, say, a $100m valuation, most investors want at least a 3x return. That means they may veto an acquisition of < $300m. By contrast, if your last round was merely at $10m post, almost any acquisition may meet the basic test for approval from your investors. And you will most likely need their approval to sell. More here: Does raising funding from VCs limit your exit? | SaaStr
- Burn rates can creep up, sometimes to an almost out-of-control level, without even fully realizing it. Founders are constantly surprised how much burn rates creep up after a big round. Folks just get tired of being more scrappy, and want more hires and reports. Salaries go up. Add it all together, and your burn rate can quickly double or more just months after you raise a big round.
- Mediocre outcomes even in fairly high-priced M&A. If you raise at $1B and are able to get your investors to sell for $1B, few folks end up happy. Late-hired employees often make close to nothing. Later-stage investors are unhappy. And often only the current management makes any real money. Even at a nominally very high price in the acquisition. There just isn’t enough to go around if you don’t sell at at least 3x the price of the last round.
So yes, a high valuation does narrow your options going forward. But done right — which is hard — a high valuation sometimes can also expand some options (more money and/or more opportunities to pursue).
It’s not always clear which is better. A high valuation is betting the good times continue forever. A low valuation gives you more flexibility. Make the right bet at the right time, with as much information as you have.
A related post here.