The trap of over-valuation and how to avoid it

The most remarkable change in venture funding since the start of the pandemic has been the steep rise in valuations.

For founders, higher valuations are generally wonderful. Who’s going to complain about getting more investment for less dilution?

But valuations that get out of whack with reality can be a trap that kills the company when it goes for funding in later rounds. With big players dabbling in the earliest stages, it’s becoming a serious danger.

Here’s what typically happens:

BabyUnicorn Raises a Pre-Seed Round

A young, promising startup called BabyUnicorn is accepted into a big accelerator like Y-Combinator. They’re in a hot space with a slick pitch and impressive founders. They’ve developed an MVP they’re starting to demo to users.

The company wants to raise $500K — $1M to give them 12–24 months runway.

If I saw the pitch, I’d look at the market size, the exit opportunity, and their pre-revenue stage. A couple of years ago, I’d say the valuation was around $6M. Now, with valuation inflation, probably $8M.

But they’ve been through YC, and they’re in the Bay Area where valuations are higher, so the company feels they’re worth $10M. Fine. That’s borderline too rich for my taste, but it won’t be hard to find investors.

After YC’s demo day, investors line up to meet them. They’re big investors with big funds who want to write big checks. They each offer to take the whole $1M round. And there are 5 of them.

What to do, what to do, what to do? We all dream of this problem — too many investors begging us to take their money.

One offers to up the ante — they’ll invest $1M on a $12M valuation. The second offers $14M. And neither demands a board seat — hallelujah! By the time the auction finishes, you’re holding 2 checks for $500K each at a $15M valuation. Holy crap! It’s off to the bar to celebrate.

BabyUnicorn Raises a Bridge Round

The drinking done; it’s time to get to work. You’ve got a product to build. And that doesn’t go as smoothly as you promised investors because, well… it never does. Never, ever. It just doesn’t.

There are problems with the software. There are problems hiring the team. The pilot customers who were so excited to try the product suddenly have higher priorities. Early feedback makes you realize you need to pivot and redesign the product. Because, well…this is what happens at every early-stage startup.

Pretty soon, 12 months have passed, and there are only 4 months of cash in the bank — time to start working on the next round of funding.

After the pivot, you’ve got a stronger product, an impressive core team, and a better product-market fit. You’ve got a nice pipeline of potential customers and a handful of pilots. You’re sure you’ll close hundreds of thousands in revenue this year and expect to reach $2M ARR by the end of the next.

If the company was worth $15M in the last round, it ought to be worth $25M in this round after all this progress.

So you contact your two big investors. One has already filled their fund, and the other has a policy of not investing in follow-ups. Damn. But no worries — 3 other funds were begging to invest.

One says they only consider investing if the previous investors join the round. Another bluntly says they were expecting faster progress. The last is interested but gags at the $25M valuation.

No need to panic — there are plenty more investors in the sea. So you make the rounds of the small VCs and angel investors. That’s when you come to me.

I look at the pitch deck, the market size, the exit opportunity, and the pre-revenue stage. I think the company was worth $8M in the previous round, but BabyUnicorn is still pre-revenue, so it’s worth at most $10M now. At $25M, no way in hell am I interested in investing. Not even at $15M.

You give up on raising the full $1M and go for a small bridge round — just enough for a few months runway so you can hit key sales milestones and justify the higher valuation. You find a handful of investors willing to put in an additional $250K at the same $15M valuation as last year, but they demand concessions like a board seat and warrants based on performance.

Your original investors aren’t pleased. A year after their investment, new investors are getting a better deal. But you need the money and control the board, so you accept the terms. The original investors give up on BabyUnicorn as a pending loss.

BabyUnicorn Raises a Seed Round

After a few more months, you’re begging the pilot customers to sign a deal, any deal, so you can say the company is in revenue.

You expect that’s the magic ticket that will unlock the $25M valuation, or at least $20M and make everyone happy. But the deals are small and highly discounted, and though it’s revenue, investors aren’t impressed.

In diligence calls, the original investors tell new investors the company hasn’t hit any of its milestones. The best offers you get for funding are at a $12.5M valuation. Board meetings turn into finger-pointing and acrimony. Maybe the company can recover, but it won’t be easy.

It didn’t have to be this way.

This own goal could have easily been prevented.

Imagine that instead of taking investment in the first round at $15M, the valuation cap was set at $10M. Then, as the company made progress, the next round was $15M. Instead of seeing the company as a failing investment, the original investors would have seen a gain of 50% in a year. Woo-hoo! They’re thrilled and promoting BabyUnicorn to everyone they know.

Imagine that instead of taking investment from the highest bidder, BabyUnicorn had taken investment from those investors that were the most committed to the company’s success. They demanded board seats which made them responsible for helping the company move forward. They not only invested in the next round but brought in other investors with them.

If you find yourself in the enviable position of having investors begging you to take their money, don’t be tempted to raise the valuation. You’re not selling a product but a stake in a partnership with you.

Yes, the valuation in the early round determines the dilution, and less is better. But it’s also a signpost marking the company’s progress. A valuation that’s too high for the current status means the company will have to work twice as hard to not only catch up with that valuation but race past it.

If investors value the company at $15M now, they’ll expect it to be at $25M next year. If it doesn’t meet the milestones associated with a $25M startup, then the company looks like a failure when the next year comes, and valuations crash back to reality.

This over-valuation trap isn’t unique to the seed round, though the influx of big VCs writing big checks to companies that aren’t ready makes it far more likely than it used to be. WeWork is a perfect example of a late-stage startup destroyed by over-valuation. The only thing wrong with a $9 Billion valuation is their investors put money in at a $47B valuation and were not happy when the absurd valuation hit reality.

Have the Right Kind of Auction

If you have eager investors, by all means, have an auction to determine which VCs will invest in the company.

But instead of basing it on valuation, base it on how they will contribute to the company’s success.

Will they take the responsibility of serving on the board? Will they invest in the next 2 rounds? Will they introduce you to other investors? Will they help you find key hires and potential customers?

Contact their portfolio companies and see which ones have supported their founders through thick and thin and which ones stopped answering the phone when the going got tough.

If you can pick and choose your investors, don’t select by the highest valuation. Instead, select the investors who provide the highest value to the business beyond a one-time cheque.

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