One of the lessons that the wild Silicon Valley venture funding environment of the past few years has clearly taught is this: Bigger valuations are not always better.
“I think we’ve all kind of seen the negative impact of having a valuation too high from the last, call it, three years,” Elizabeth Yin, co-founder of Hustle Fund said onstage at TechCrunch Disrupt last week. When a VC bull market hits and startups are able to easily raise a lot of money before they have real, provable businesses, they’ve set themselves up for difficult times.
Because “the bar is higher for that next round,” she said. The general rule is for each early round, business growth should justify double, or possibly triple, the previous valuation, Yin said.
So early valuations “shouldn’t be anything really crazy that you don’t think you can grow into realistically with your traction, because it always catches up with you,” she said.
If the company fails to grow into a lofty valuation, it could wind up burning its most valuable employees, said VC Renata Quintini, co-founder of Renegade Partners.
Most startups grant stock to employees, or sometimes grant stock options — which the employee is required to buy. And most startups offer that stock as a significant portion of their employees’ salaries. People join startups because they believe if they help build the company, their stock will pay off. So, obviously, it is not good if employees’ stock grows less valuable over time.
“If that gap doesn’t close, you’re actually disincentivizing the people that joined you early on,” Quintini warns.
A much better way to raise money is to “create a tight process,” by setting reasonable valuation expectations from the get-go, VC Corinne Riley, partner at Greylock, said onstage. “You don’t want to be dillydallying and have a multi-month round. You’re wasting your own time. You’re wasting the VC time,” she said. “You want to know exactly how much you want to raise.”
Quintini advises founders to have ranges in mind for both an amount and a valuation. To do that, she says, a founder should spend more time in an information-gathering phase than in an actual pitching phase.
They should ask VCs in their network their opinions on their valuation. They should know what type of market they are in and what the multiples on revenue or other pricing metrics are in vogue for their area at the moment. They should carefully consider how much dilution they are willing to take — that is, how much of their company they are willing to sell off and how much of a stake they will retain after the round.
Should the founder want to sell a smaller stake — 10% versus the more typical 20% — the founder should find out which firms would even entertain that idea. Many firms won’t bother with small stakes, as that decreases their chances for a big return.
Coming into the pitch meeting wanting too much for too little means “you better have a fantastic business and be an outlier company to back it up; otherwise, you’re actually going to be turning VCs off,” Quintini says.
If a VC comes in with a term sheet that wildly beats all the others in valuation, founders should look at the fine print. Has the VC banked the term sheet toward giving its firm outsized power? This could also mean that the company won’t be able to convince other VCs to invest in later rounds.
Startup accelerator Y Combinator distributes a sample term sheet that shows off what most VCs consider standard terms. These cover everything from voting rights to board seats.
“I’ve definitely seen a number of my founders, especially international companies, get all kinds of term sheets with all kinds of terms that I would consider nonstandard,” Yin described, such as “weird board configurations” like the VC wanting multiple board seats, or “all kinds of liquidation” preferences. Anything above a “1x” liquidation preference means that the investor gets paid out more money, and first, should the company sell and isn’t standard.
In addition to being prepared to negotiate on dollar amount, valuation, and stake size, founders should be prepared to negotiate board composition and items like who gets to choose the independent board members. Whatever you decide on the terms that give VCs power could impact your company, and its future valuations, forever.
“I encourage our founders to turn the very nonstandard things down. And then there are some others that are borderline. And maybe you take it because you don’t have any other options, but, once it’s done, it’s really hard to unwind,” Yin says.