The High Valuation Trap – Why startups shouldn't maximise on valuations (even if they can)
Valuing a startup has never been easy. Despite many methods that have been developed and tested, it is still a matter of balance between supply and demand, risk and return and often pure guess.
It is not uncommon that entrepreneurs come up with very high valuations that are totally disconnected to where their ventures are – what value and traction they collected until the time when they ask for investors’ money. The moment they find the first investor who accepts a high valuation without questioning it, it is the moment when things start going in the wrong direction.
Unexperienced entrepreneurs are tempted to defend their equity and minimise dilution. Existing investors in their businesses might also be happy because the paper value of their share might increase significantly. It is too easy to overlook negative consequences of setting up high valuation as they are likely to come at a later time.
1. Wasting time on trying to find the “perfect” investors
There are many reasons why entrepreneurs set valuations high when they go to investors. Many of them overestimate the importance of how much equity they are giving away. Also, they protect their own shareholding without taking into consideration that without the investors’ money, their equity is worth nearly nothing.
In certain cases, high valuation is a result of comparing their own company to other startups. This happens by relying too much on publicly available information on crowdfunding and/or data platforms. This type of benchmarking, often without insider knowledge of other startups, can be very misleading.
Recently, we even came across an opinion that if you don’t value your startup high, investors will think it is worth nothing. This is wrong – investors would instead think that you are not being realistic.
In any case, setting high valuation on an early stage startup will turn off investors because they will see it as an unattractive opportunity where risks are high with a potential ROI lower than what it should be. Entrepreneurs might waste a lot of time trying to find an investor who can agree on the given valuation and will turn down those that can invest quicker but at lower price. In early stage startup world time is equally if not more important than money.
2. Troubles in closing the round
When entrepreneurs are challenged on their valuation, they will try to prove you wrong by ushering that they already have investors who accepted the high price. This is not a strong argument if we are talking about less than 50% of the round size. It is possible to attract some cash at a high price, particularly from less sophisticated and less experienced angel investors (not to mention friends, family, and fools), but the bigger the round is, the more difficult it is to find enough people who are willing to invest at a high price.
This then leads to the situation where either not enough funding can be raised, or the price has to be decreased in the middle of the funding round. The second situation can be, in a way, a solution. However, it is not an ideal one as entrepreneurs will have to face existing shareholders and might end up losing credibility and time.
3. Pressure of the next round
It is common practise that businesses raise multiple rounds and it is also a common expectation that every next round is raised at a higher valuation to reflect progress and to keep the first investors satisfied. What entrepreneurs often forget is that expectations towards their businesses grow with each new round and new investors will be looking at numbers and performance, not the potential of the market and/or the team.
Entrepreneurs tend to be overoptimistic and plan their rounds without taking into consideration the obstacles on the way. If a business raised their first round at valuation that is far from the real value (and the later the stage, the more crucial is revenue and profit), raising every next round will be a tough, if not impossible task. It will be more and more difficult to meet performance and valuation expectations from new and existing shareholders respectively.
4. Investors Pressure
Investors that pay high prices for their shares will expect a lot, which means fast progress and fast revenue growth in their investment. This is not always possible if the company is behind in terms of technology, team and sales development. Entrepreneurs might find themselves in a very uncomfortable situation where they want to keep investors happy, but know they need more time to reach the desired stage. It is a psychological pressure on the CEO, and can potentially cause conflicts, misunderstandings, and errors in the company.
Keeping all of this in mind, valuations should not be the main concern of entrepreneurs in the early stages, but should be a part of the long term strategy that is well thought through. There is nothing special about keeping a majority of the shares since business will not be better as a result of that and the real value of the business is only the one at the exit, which tends to be a long and complex journey. Sticking to your gut when raising investments at a high price might just be a won battle in a lost war.