Why “pulling off” a high valuation can backfire

May 28, 2018

Written by: Itay Sagie, Co-Founder at VCforU.com

 

 

 

It seems natural for every entrepreneur to believe their company's valuation is higher than what investors think. It is true, that they have put blood sweat and tears into their startups and have earned nothing during this time.

When an investor comes their way, they would like to get the best terms and give a way less equity. As an example if they raise $1M Seed round, they don't want to give away 33% equity (which is quite common) but only 5% equity. This would be the difference between a $3M and a $20M post money valuation, the latter being extremely high and very uncommon for a seed round.

 

In some cases companies do manage to “pull it off” and convince someone (probably not a professional investor) to invest at such a high valuation, however this may backfire, and here is why:

 

It is usually the case that the Seed round is not the last round a company will raise, later comes round A, B etc. It is also usually the case that companies don’t materialize their business plan as written. Normally revenues are not as high as planned and take longer than planned to achieve. Now, you are raising your A round, and naturally your previous investors want an “Up-Round”, meaning the Pre-Money valuation of the A Round should be higher than the Post-Money valuation of the Seed round. So at least $20M valuation. Any offer less than that will most likely be rejected by the Seed investors and it would greatly damage your record. The problem is that unless you have greatly outperformed your own forecast, the A round investors will not accept such a high valuation. They will believe you might be worth far less, say $3M or $4M. Leaving you without the ability to raise your A round, meaning you may end up closing the company.

 

In short, it is always better to ask for a reasonable valuation that is accepted for your stage and industry. Instead of worrying too much about valuation, I would make sure that the round size is enough for you to reach your big milestones, ideally reach initial sales. You don’t want to get stuck without cash before having achieved your milestones, as this capital would be much harder to raise and it will most likely be at a very low valuation.

 

Second, it is best to raise capital from professional investors, even if they request more equity than non-professional investors. This is not a zero-sum game, you will benefit from professional investors in many ways. They will most likely be able to participate in your next rounds, they will provide guidance and help you grow your company so that your equity will be worth much more down the line.

 

THIS ARTICLE IS WRITTEN BY VCFORU.COM LTD. AND IS PROVIDED FOR GENERAL INFORMATION PURPOSES ONLY. YOUR USE OF THIS INFORMATION IS AT YOUR OWN RISK. DO NOT USE THIS ARTICLE WITHOUT SEEKING LEGAL, FINANCIAL AND OTHER PROFESSIONAL ADVICE. THE PROVISION OF THIS LEGAL OR FINANCIAL ADVICE. VCFORU LTD. WILL NOT BE LIABLE FOR ANY DAMAGES, LOSSES OR CAUSES OF ACTION OF ANY NATURE ARISING FROM ANY USE OF THIS ARTICLE.

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