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:
High valuation has two 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
These are significant advantages of a higher valuation.
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
So yes, a high valuation does narrow your options going forward.
But it also expands some options (more money and/or more opportunities to raise).
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.