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The Valuation Dilemma

Eric Hanson
September 6, 2022

Before a raise, many entrepreneurs grapple with the question of where to set the valuation of their company. The past couple of years have been a rollercoaster in startup valuations: Since 2020, an influx of money being invested from non-traditional investors and later-stage investors going downstream caused pre-seed and seed valuations to skyrocket. More recently, the news for raising seems to be more doom and gloom.  Still, even with a dip during Q1 and Q2 of 2022, investors are pouring record amounts of money into startups. Seeing other startups (especially competitors) raising at inflated valuations makes it tempting to hyper focus on securing the highest valuation possible. There are advantages and disadvantages associated with raising at a high valuation; therefore it is important to weigh the short term and long term implications of where you set your next valuation.

When the market is hot, it’s  tempting to take advantage of the frothy market by raising at as high of a valuation as possible. Taking more money (which you can do at a higher valuation) means a longer runway and less time worrying about finding your next investor. If you face fierce competition, a high valuation signals a winner, or future winner in the space. Appearing to beat out the competition makes landing deals, hiring highly qualified employees, developing a product and landing future investors an easier proposition. And, of course, a higher valuation usually means less dilution for you and your employees. Setting a high valuation certainly has its advantages, and can provide an instant boost to a startup, but it’s not actually that simple.

The bottom line is that the valuation is what your company is supposedly worth: if you raise at a valuation that you’re not able to grow into and take on more money than you can effectively use, you’re setting yourself up for failure. Let’s look at some of the potential long-term and even short-term drawbacks. Things rarely go according to plan for startups, but in a perfect world, you will want to create a record of raising every 12-18 months, where each raise is larger and at a higher valuation than the previous raise. Flat rounds and down rounds tarnish how investors and potential employees see their chances to profit with you. Down rounds even trigger anti-dilution clauses which further dilute founders and turn the valuation of your previous round into a pyrrhic victory. And that’s assuming you’re able to raise again at all after failing to fulfill your promised potential value.

Looking even further down the road, exit options can narrow after a frothy raise. As you all hopefully know, acquisition is the most frequent path to a successful exit – and something most founders don’t start thinking about and planning for nearly early enough. Even angel investors will be looking to make at least 3x on their investment, and if the valuation was inflated, investors can veto deals that do not meet their expected returns.

So how can an entrepreneur decide what their next raise will be, keeping in mind fiduciary responsibilities to shareholders and long term goals? Sometimes foregoing the inflated valuation instead of negotiating other founder friendly terms can pay off big time in the long run. There are a few clauses that founders can use to anchor their negotiations. Here are a few ideas:

Financial terms that maintain ownership for founders and current investors

  • Expand the stock option pool post money, so that new investors share in the dilution
  • Require an investment that includes a mix of both equity and debt (Maybe 70/30)
  • Remove liquidation preferences and accruing dividends

Control terms that make life more pleasant for the founders

  • Frequency of board meetings
  • Reduce the founder shares subject to reverse vesting
  • Reasonable salary

This type of compromise works for the entrepreneur, who sees valuation as just one element in long-term success, and the investor, who is willing to make a few concessions to get what is perceived as better deal terms.

A reasonable valuation will also result in something that all entrepreneurs should be searching for - good, long-term relationships with experienced investors. For example, attracting an investor with deep domain expertise might fill critical gaps that are slowing your growth. Some investors can help with distribution relationships or other business development endeavors. An inflated valuation can scare away the type of investors that startups need- ones that have the experience and knowledge to partner with a startup all the way to an exit.

In short, be strategic when you’re raising. Setting a valuation is more of an art than a science, and you need to be ambitious but tactical in order to maximize your future options.

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