I recently read an interesting post at entrepreneur.com arguing the down side of a mega valuation when raising initial capital. During the read, I quickly recognized that the author was a venture capitalist himself. Despite my recognition of the inherent conflict of interest, what was said in the last paragraph redeemed him for me. I think his points should be well taken, so I want to present the argument in a more digestible way—backwards!
The important thing for everyone at the table to remember is that by working with others (either receiving funding or placing it), you are taking a piece of the pie. Don’t get greedy and white-knuckle the whole pie. By aligning the right incentives, everyone will work to grow the pie together. Much better to have a smaller piece of a much bigger pie.
Under what circumstances should an entrepreneur consider a smaller valuation when raising money?
A lower valuation than what you want is a hard pill to swallow. Your blood, sweat and tears have gone into your baby, and you have a very high opinion of what you’ve got. Investors recognize this, but they are thinking about the three points listed below. So what do you do about these conflicting positions?
Build in entrepreneur-friendly components that make it up to the founders, such as option pools, preferred returns, or performance compensation. Keep in mind that these items will help to offset the pain of loss, but won’t really help with the ego. So as long as you and your investor can come to an arrangement that will lead to a payout that you’re comfortable with given achieving growth goals, you as the founder should be compensated nicely, and they will be happy about a valuation that they can swallow. Think win-win.
So why should an entrepreneur consider a smaller valuation when raising money?
It aligns incentives for the VC much better. You have to remember that investors put money in ventures recognizing that they are extremely risky. Just face the facts that 90% of investments fail. And with risk must come a commensurate amount of upside. They are looking to make at least a 10x on their investment in you. 2x or 3x is just not enough. Compare for what amount similar companies in your space are exiting, and work backward for a maximum valuation of your final fundraising round, a series B for example. If your series B would be $5M, with an exit of $50M, then your initial round, if it’s a series A should probably be no more than $2.5M, and probably less.
Down rounds create a wealth of problems. Unfortunately investors don’t take too well to investing money in a company at a valuation lower than the initial round. It carries with it quite the reputation—and one that you want to avoid. And what’s worse, it’s not the investors typically that suffer the most, it’s the founders. They’re the ones that have to give up more in the equity round—completely reversing what the entrepreneurs were trying to accomplish initially when they raised money at such a high valuation.
Haggling is a bad way to start a relationship. As I’ve written in previous articles, the investor-entrepreneur relationship is one that is just like a marriage. You will work very closely with them for the foreseeable future, and you can’t just get rid of each other so easily. So don’t start your relationship over a heated and costly debate. A black eye will be remembered for a long time to come—and may result in very negative future consequences. You want to keep the relationship strong so that the investor or investment group considers you one of their best investments and is not only rooting for your success, but helping in anyway they can.
Coming to a valuation that both sides considers “reasonable” will be one of the most difficult things you do in fundraising. Keep these things in mind and discuss them with your investor, and you will be able to come to a spot where both parties can win.