Tag Archives: Valuation

The benefits of raising at a slight valuation discount

In an earlier post on fundraising do’s and don’ts, I wrote that startups should optimize for success rather than valuation. Specifically, I wrote that sometimes it’s worth “taking a few additional points of dilution [by accepting a lower valuation] to get the right partner in your company”.

Marc Lore, the founder of Jet.com which was acquired by Wal-Mart for about $3 billion in cash and $300 million in Wal-Mart shares, gives several other reasons why taking a slight discount on your company’s valuation is likely to increase your company’s likelihood of success.

In addition to letting you work with the right partner for your company, the benefits of taking a slight discount on your company’s valuation are that it:

1. Increases investor demand for the round, thereby creating scarcity which sometimes even results in a higher final valuation for the round.

2. Makes it more likely that the round’s investors have a nice paper return by the time of the next round, thereby making them more likely to be happy investors who refer the company to other investors.

3. Lowers the likelihood of a potentially morale hindering future down round.

4. Increases the pool of potential buyers of the company by not boxing out smaller buyers who would otherwise not put in the time to evaluate the company due to believing that they wouldn’t be able to meet its valuation expectations.

The cost of raising too much capital

Most startups believe that raising more money is better. Startups are already undercapitalized relative to the incumbents that they’re trying to displace, so the more capital they have to close this gap the better.

While this is partially true, it comes with a very important caveat. And this is that the relationship only holds up to a specific point.

Having some money is almost always better than having no money. It lets you hire people, build a product, and hopefully get people to use that product.

However, raising money also carries a cost. Specifically, it sets a valuation for your company. And a valuation sets expectations.

Startup valuations reflect future expectations for the company, not its current performance. The company needs to use the capital it has raised to fill in the expectations set by its valuation. And the more you raise, the more difficult this becomes.

We can see that this is the case by thinking about the edge case of raising infinite capital. If a startup raised infinite capital, there would be a point beyond which it cannot put that capital to efficient use. Even if we ignore all other constraints, a startup is constrained by its market size and the time that it needs to spend to execute on projects so as to grow into that market. Taken together these factors create an upper limit for the amount of capital that a startup can effectively put to use in a given market during a given period of time.

When funding is readily available, you might be able to raise more than this upper limit. But just because you can doesn’t mean you should.

Beyond a certain point, the shoes you’re trying to walk in will just be too big. Your feet won’t grow fast enough, you’ll end up with blisters on them, and you’ll be forced to buy smaller shoes.

And that’s where this analogy breaks down. It’s easier to find smaller shoes than to structure funding at a lower valuation.

Metrics in startup press releases

We recently completed a new funding round for one of our startups. The startup prepared a press release for the round and the founder shared it with me to get my feedback.

As is the case for most press releases around funding rounds, it didn’t contain any numbers highlighting the company’s absolute performance. Instead, it shared growth rates for specific performance metrics. So rather than say that the company achieved X on metric Y, it said that the company achieved a growth of Z% on metric Y during a specific time period. This is a tactic that startups often use to signal how well they’re performing without sharing their actual performance. However, unless we also know the base figure from which the growth rate emerged, it doesn’t carry much insight into the company’s actual performance.

I believe that companies shouldn’t fear sharing their high-level absolute performance metrics like their number of active users, transactions, and net revenue. The reason is that being aware of an opportunity and being able to capture that opportunity are very different things. Companies succeed because of their ability to capture opportunities, not because of their knowledge of the size of the opportunity in a specific market.

However, my feedback on this press release wasn’t about the use of growth rates rather than absolute performance metrics.¬†Instead, it was on the specific performance metric which the company was using to demonstrate its performance. In particular, the company had chosen the growth in its valuation as an indication of its performance.

A startup’s valuation is simply the value which one investor, or a small group of investors who are strongly influenced by the lead investor, places on the company at a given point in time. While it is derived from the fundamentals of the company, it’s subject to the whims of a small group of people and market multiples at a certain moment in time. What ultimately matters is not an intermediate valuation but the valuation at exit. And that will be determined by a much larger group of people (if not the entire market in the case that the company goes public) at a point in time where market multiples may be very different.

So rather than highlight your company’s valuation in a funding round, if you want to show how well you’re performing, you should highlight a fundamental performance metric like your number of active users, transactions, or net revenue. That’s much more reflective of the underlying strength of your company than the valuation which one or a small group of people assign to your company at a given moment in time.

What valuation are you looking for?

A very common question which investors ask in their first meeting with an entrepreneur who’s raising money is what valuation the entrepreneur is looking for.

Answering this question head-on is very risky. If the valuation you’re asking for is deemed too high, the investor may think that you’re being unrealistic and therefore not move forward with follow-up discussions. If the valuation is deemed too low, the investor may conclude that there’s something wrong with the company. This may also lead them to not take a follow-up meeting.

An entrepreneur articulating an expected valuation for their startup is problematic because valuing companies, and especially startups, is an art, not a science. A valuation that you see as fair may easily be deemed to be too high or too low by an investor with a different perspective. Articulating an expected valuation opens the door to these disagreements at a time when you should instead be focusing on getting the investor to better understand your business and evaluating whether you’d want to partner with them.

As a result of this problem, I recommend that our entrepreneurs not articulate an expected valuation when fundraising. Instead, I recommend that they share how much money they’re looking to raise, describe what they’re going to use the money for, communicate the details of any prior funding rounds that the company may have had (milestones achieved, metrics, and funding terms), and state that they’re going to let the market set the terms of the current round. This gives investors who are interested in investing in the company all the information they need to come up with an offer.

Most of the time, this information is enough for interested investors to make an offer. However, sometimes investors continue to push the entrepreneur to articulate an expected valuation.

In this case, I recommend communicating how much equity you’re looking to share in the current funding round. Since you’ve already shared how much you’re looking to raise, combining this information with how much equity you’re looking to share implicitly signals the valuation you expect for your company.

However, by focusing the conversation on the funding you need to succeed and the amount of equity you’re looking to share to remain motivated as a founder, you show that you’re optimizing for the success of your business. You’re not optimizing for valuation.

And since investors want to partner with founders who optimize for success, this approach makes them much more likely to want to invest in your company.