Our most ignored advice: Don’t focus too much on your valuation.
With the fancy headlines in the magazines and great fundraisers looking like rock stars, we understand it’s hard for young founders not to go down this road and maximize valuations from the start. With the term “unicorn” being a shiny goal for every founder, it’s tempting to overly focus on the valuation, instead of taking a step back and understanding the consequences. Don’t get us wrong, of course it’s important to achieve healthy valuations and growth, but still you should be aware of the possible faults of focussing too much on this number. In fact, we saw that the obsession with maximized valuation can come back haunting you quite often.
Let’s show you some possible consequences of this strategy that we experienced as founders and investors.
👍 Pro:
But first: What advantages does maximizing valuations have?
Minimize your dilution.
It's true, the higher your valuation, the less equity you need to give up in exchange for funding. However, this might be short sighted after all. Often your dilution does actually not make a big difference for potential exit proceeds. What makes a difference instead are liquidation preferences… but not in the way you like it.
With capital being easily available over the last couple of years, many founders raised funds they would not actually need, which in turn build up larger cost bases and liabilities for the coming rounds. So minimizing your dilution can also be achieved by raising money you actually need to progress to the next stage, instead of firing up your burn rate.
👎 Cons:
As we feel that for most founders no actual down-side exists for maximizing valuations, let us show you what we observed more often than we liked it:
Higher pressure on the next round!
With higher valuations, you're putting additional pressure on yourself to perform in the next funding round. Investors will look at the relative increase to assess your trajectory. This pressure will accumulate over time and if the development is not as desired - you will have a harder time to raise money.
The effect correlates not only by increasing your burn rate and therewith liabilities, but especially with investor expectations. You raised your pre-seed round at a €10 million post-money valuation? Your seed round should better not be just raising at a €10 million post-money, effectively not gaining any value. Especially, as your company will be valued by metrics as the rounds go on (even more so in these post-covid times, where most VCs do want to see traction).
The waterfall can eat up your proceeds!
By focusing too much on your valuation, you are losing sight of the most important incentive: Your exit proceed! If your company ultimately underperforms, your proceeds will be eaten by the liquidation preferences of your investors. Generally, with higher valuations, investors want to get higher liquidation preferences, given the higher risks. Therefore, you should not only focus on dilution, but more importantly on the payout structure.
This is especially important in later stages, where the hunt for highest valuations can destroy your whole exit scenarios as a founder.
One example that highlights the potential pitfalls of focusing too much on valuation is the recent exit of Gorillas to Getir with a deal value of $1.2bn - which by itself is absolutely amazing: a unicorn! However, after dropping from a $3bn valuation, the Gorillas founders & management received “only” a bonus payment of €10 million collectively, instead of receiving any proceeds from their actual shares (see Deutsche Startups). This is almost entirely due to their waterfall or liquidation preferences. Even though the compensation was predominantly in shares, the €100 million payout only went to the latest (bridging) investors. So even exiting a unicorn can leave you as a founder at the grace of the investors and receiving less than 1% of the total payout.
More on liquidation preferences: https://capnamic.com/post/the-liquidation-preference-dilemma
You block smaller (but life-changing) exits!
A high valuation also means that your company needs to achieve a higher exit multiple for your investors to get their desired return. This could limit your options for potential exits. In fact, most VCs want to achieve certain multiples from their successful startups and once you get to this level, there will also be interest pouring in from potential acquirers. So these early acquisition talks will be blocked off by your institutional investors at this stage.
Even if your VCs might want you to continue, smaller exits are often a completely life-changing opportunity for you (and your team). Making your first million, taking money off the table, starting to invest into new asset classes, etc - not available because of expectations on investment multiples.
Take the example below, while the founder in this example is more than doubling the Enterprise Value from €50 million to €120 million from Round 4. to Round 6, the value of the founder’s shares only increase by 54%. For most founders, an exit with €20.5 million is probably as much life-changing as an exit with €31.5 million.
You limit exit routes!
When smaller exits are not possible, this naturally limits your options for potential exits. Many acquirers will drop out because of the higher price tag, which leads to a limited pool of potential buyers for you. However, you want as many potential acquirers as possible, to get the negotiation rolling in your favor!
Conclusion
In conclusion, while maximizing your company's valuation can seem like an attractive goal, founders should be aware of the potential downsides.
While high valuations can minimize dilution, they also put pressure on the next round and limit potential exit routes. Moreover, focusing too much on valuation can cause founders to lose sight of the most important incentive: their exit proceeds.
This is especially important when it comes to the payout structure and liquidation preferences. Founders should therefore balance the need for high valuations with a broader view of their company's growth and exit strategy. By focusing on sustainable growth and avoiding the pitfalls of a narrow valuation-based strategy, you will most likely have an easier life later on in your journey.
Are you a founder and don’t know how to think about your valuation?
Hit us up, we are happy to give feedback: www.jvh-ventures.com/pitch