It’s time for my semi-annual blog post haha. I want to write more frequently, I really do. But I get caught up listening to pitches and whatever I’m helping a company with and it goes by the wayside. Excuses. Excuses. I know.
Valuation has been a big topic in recent years and two years after the mythical bubble was forecast to burst I have a few thoughts to share.
I’ve passed on a larger than normal number of companies recently over valuation. And that’s odd because we’re past the crazy frothy period of 2015. I don’t nit-pick over valuations typically and I’m not one to micro-optimize terms. I’m looking for fair deals that motivate the entrepreneur and come with a nice and clean cap table and vanilla terms so we have no objections when raising money in subsequent rounds. Pretty straight-forward stuff.
That’s why I’m disappointed when founders come forward with absurd, crazy, eye-popping seed-stage valuations. Why don’t I pay up and shut up? Well, beyond the very obvious fact that high early valuations affect future returns, they also set up a very high hurdle the company has to cross before raising a follow on round at a commensurately higher valuation. They create unnecessary execution risk and can lead to Hail Mary behaviors.
Last year an interesting company came to me (pre-product, pre-revenue, interesting team but they weren’t 3x entrepreneurs with decacorn exits – just good, solid entrepreneurs). I liked the concept. I liked the space. I liked the team. All good. But the valuation was breathtaking…and we’re not talking AI or another flavor-of-the-month here. Wow. I told the founders the valuation was extraordinarily high but I’d love to hear what they thought justified it. I was prepared for some hustle and a good back-and-forth about their genius business model or the secret sauce in their brilliant algorithm or the insurmountable moat their technology ensured or how they crushed it in user tests. Instead the answer was “We’re a San Francisco company so we feel we deserve this valuation.” Pick me up off the floor. That was such a deflating answer. No hustle. No insight. No passion or conviction. Just entitlement. Needless to say I didn’t write a check. Yikes.
I found another great company recently that ended in a #fail for a different reason. I loved the founder. Super high hustle. Smart. Scrappy. Great UX chops. All the things I like. The product is brilliant. It is. But there was no customer feedback as of yet so it’s a big bet. But I was willing to take the gamble until the conversation about valuation. The number was big. I gulped and asked nicely why he felt it was justified. The answer I got? “Well we raised our friends and family round at a very high valuation of X and only gave away a small amount of equity. So we need the valuation to be Y because we don’t want to disappoint our early investors. Plus we have a lot of interest.” ARGH. Friends and family are not usually valuation sensitive. Many probably don’t know what’s reasonable. They’re investing because they believe in you. But don’t take advantage of that and command an absurd valuation to minimize your dilution. One of two things will happen: you’ll have to go back to them and explain you’re doing a “down round” or you’ll face the risk of not being able to raise money because you’re trying to get the valuation up. If you are able to defy the odds and raise a nice up-round then you’ve set yourself a BIG hurdle for the next fund raise. You’re going to have to have a super duper home run to get there. And that could lead you to do ill-conceived Hail Marys. I’ve seen that movie and have never liked the ending. See above. Read Good to Great. Be sensible. Take it step-by-step. Yes, reach for the stars, but climb a ladder to get to them.
I had a third #Fail around a cap table. The founder launched his app and it took off like a rocket. Totally broke, out of desperation, he took a very small check that felt huge at the time but gave up an enormous slug of the company to get it. That’s just a terrible burden to carry forward. In a situation like that, I could get actively involved, meet with the initial investor and try to work out something that’s a #WIN for all while not polluting the cap table but that’s a big expenditure of time.
So founders, please think sensibly about initial valuations. I know this sounds self-serving but I think it serves your interests best. Oh and if you are going to go big, then have a fantastic story (product, IP, traction – SOMETHING!) to back it up.
2 thoughts on “Talking numbers or why valuation REALLY matters”
Great article! There is such a delicate line between the confidence it takes to create a startup and the hubris that often creeps into the minds of us founders.
It’s a very good article Mark, and wise words. I am curious though, how do you determine valuation at the stage you describe? It always seems like a dark art. We didn’t take outside money until we had a decent chunk of recurring revenue and a solid pipeline so it was somewhat easier to set a valuation based on a multiple of forward looking ARR. In addition there were comparables we could point to. We also had a valuation history that was fairly defensible, e.g. we issued options at valuation X and then sold equity at 3X because revenue was growing at that rate.
I am mentoring some very early stage start ups. I am stumped by how to advise them
PS: I love the “We’re a San Francisco company so we feel we deserve this valuation.” It would be even less effective for us. We are in Newark NJ, cos it’s cheap.