It’s common for early stage entrepreneurs to obsess about their valuation. Valuation times your stake equals your wealth – why wouldn’t you obsess about that? It is also the one number that colleagues, peers and even your grandmother can use to judge how successful you are.
Valuation is central to trade-offs affecting a business, but it also comes along with psychological baggage that weighs on cool decision making. For a startup, the goal of financing should be to increase the long-term probability of success. When entrepreneurs use it as a scorecard, they miss the bigger picture and it hurts their business.
Over-focusing on valuation leads to common mistakes:
Objective measures of the financial value of early stage ventures are elusive, so coming to an obviously “correct” number is impossible. It is more productive to think of valuation as a tool – one parameter in a series of transactions that are critical for long-term success. Thinking of valuation as a tool that you will deploy over a series of funding rounds helps avoid the emotional and intellectual traps that make agreement on investment terms difficult.
The valuation of your current round impacts your future rounds. Set it too high or too low, and you can get yourself into trouble:
A high valuation risks being “priced for perfection”: any delay or misstep can turn future financings into down rounds. Down rounds can be surprisingly difficult: no one wants to catch the proverbial falling knife. Investors have a lot of places to put their money, so investing in a startup whose value is declining, at least on paper, is a tough sell.
A low valuation can mean a short runway or limited equity for future investors. If you try to avoid dilution by raising too little money, you may lack the cash you need to meet meaningful commercial milestones before you raise again. Without clear progress you’ll have a hard time bringing in new investors. On the other hand, if you sell too much equity now founders will face substantial cumulative dilution in later rounds, potentially undermining the motivation that comes with ownership.
A “good” valuation strikes a balance between these considerations, providing enough cash to make meaningful commercial progress (even with the inevitable delays and missteps), while keeping enough stock in the hands of founders to make future fundraising possible without radically changing incentives.
It’s often worth accepting a lower valuation to get the right investor base – i.e. investors whose participation increases the likelihood of success. Sophisticated investors with experience in your industry may be more attuned to risk than others, leading them to seek a lower valuation. But investors with a highly relevant network, experience, expertise and ability to attract additional investors can make you more likely to succeed, which more than makes up for the lower valuation.
The valuation of the current round should anticipate the future financing needs of the company, and allow for consistent step-ups in valuation through multiple rounds of financing. To think through what this sequence might look like, founders need to evaluate the types of exits that are achievable in their industry: have IPOs happened, and at what valuation? How might you company compare? Who are the natural acquirers, and what prices have they paid in the past? Honest answers to these questions give founders a ballpark exit valuation, and by anticipating financing needs they can chart a logical fundraising path with valuation step-ups in each round.
A “good” valuation puts you on a sustainable path for steady growth to a realistic exit – an IPO, and acquisition, or even (gasp) long-term generation of free cash flow.
Valuation is also a sensitive term because it tends to trigger strong emotions. Founders are passionate people – you have to be to found a company and pour in the effort required to succeed. As a result founders often identify closely with their companies. The valuation – a fair financial measure of the current value of the company – feels like a reflection of personal worth as a human being. Founders usually recognize this and try to dissociate, but it is a real dynamic that can cloud judgment. That’s why I say “valuation is just a number” – it’s one parameter in an overall equation, and freighting it with too much emotional baggage is counterproductive.
The statistics are clear: most startups will return nothing to their founders. So don’t obsess about valuation; use it as a tool to maximize the probability of success.
By Jason Whaley, General Partner
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