The Risk Of Accepting A High Valuation

If your dream investor offered to invest in your startup at a higher valuation than you planned to ask for, would you take the money?

Of course, right?

High valuation = low dilution = more equity for the founders and/or more to offer in future rounds. Done deal. Send over the term sheet please.

Turns out it’s not quite that simple. Paul Graham agrees:

Most founders don’t think about the downsides. My last startup made this mistake twice. We raised:

• A seed round at a $20 million cap with $0 recurring revenue (~$250,000 total revenue)

• A Series A at a $85 million cap soon after launching our subscription offering

At the time we were thrilled. In fact we negotiated hard to get those terms.

We were a hot startup, but the terms put us in a tough spot for any future rounds.

We put ourselves on a treadmill where we needed to generate a ton of revenue fast to grow into our valuation before we burned through the investment. Otherwise, eventually, we’d be dead in the water.

Today I’m sharing:

• How to know what valuation to raise at

• When are terms too high?

• Why do investors make high offers?

• Why do founders accept high offers?

• What actually happens when you accept a high offer?

The Risk of High Valuations

How to Know What Valuation to Raise At

First things first. Set an (internal) benchmark for the valuation you want to raise at before you even engage investors based on how much capital you’ll need to raise the next round, and current market conditions.

Last year I shared my framework for how to determine the right valuation for your startup:

1. Map out the milestones you need to hit for your next round

2. Understand how much you expect to burn to hit those milestones

3. Calculate how much you need to raise, given that burn + 12 months of runway

4. Determine your target valuation based on how much you need to raise and expected dilution

5. Check the markets — does that target match the current reality for the stage you’re at? Adjust if needed.

The full piece goes into more detail and shares formulas to help you make calculations along the way.

When Are Terms Too High?

Even with a target it can be hard to get a good sense for how high is too high.

The easiest way to do this is to consider the current state of the market, and also comparable startups that have raised in the past via Crunchbase.

Another way is to consider your next round. What valuation do you think you’ll be able to raise at, then? If you hit all the milestones you outlined, where will your revenue be? Can you estimate your growth rate? How much will you have validated about your market? Again, consider comparable startups — where were they at when they raised that next round?

It’s nebulous but try to be honest — if you can’t see yourself being in a position to raise at a considerably higher valuation than you the terms you’re being offered now, you’ll be painting yourself into a corner by accepting them.

At best, investors may take it as a sign that you haven’t grown as much as you expected to.

Why Investors Make High Offers

Once an investor has made up their mind that your startup is going to become huge they’ll fight hard to invest.

As their conviction about your startup increases so does their determination to join or lead the round.

PG offered a follow up to his tweet that got me thinking about this:

Call it FOMO, call it conviction… whatever it is, investors know that one massive homerun can make their career and dramatically increase their profile both within and outside of their firm (not to mention their wealth).

Good investors like our Series A lead Andrew Chen from a16z also know that if a startup ends up being a homerun, it will be worth so much that the difference in valuation (and therefore how much the investor owns) will effectively wash out.

Sam Parr wrote about Andrew’s thoughts on the topic after spending time together IRL:

Other factors that can lead to receiving offers at high valuations are:

• A broader bull market → When your sector is hot you’ll have more investors searching for the right companies within it to deploy capital into.

• A competitive round → If you’ve done well at creating hype for your startup (here’s my playbook on how to do that) then you’ll likely have multiple well-regarded investors competing to lead the round.

Having some level of agreement among investors that your startup has a high likelihood of becoming a unicorn (or larger) is a massive positive signal for other investors. They trust each other’s opinions since they each see so many deals. If multiple investors see signs that your startup will succeed, other investors will jump in just to not miss the boat.

Peter Thiel even says that his biggest investing mistake was not participating in Facebook’s Series B (after originally making the first outside investment in the company):

Why Founders Accept High Offers

When things are going right with your startup it can feel like nothing could ever go wrong.

If you’ve received high offers it likely means you have investors, who see lots of deals, telling you your startup is destined to be big. And you probably also have customers loving your early product.

Maybe you’re thinking you have the Midas Touch in your market and you understand it better than competitors do, will, or could.

All of a sudden you’re expanding your vision and thinking about all of the ways you could use more capital.

I call this Shiny Object Syndrome.

It comes from a good place — founders want to “invest” in growing faster, or doing more things to help their users. But most great startups are built with relentless focus on what they can do better than anyone else, not trying to do more and more things.

WeWork is a great example here. What was a good coworking company all of a sudden had schools, apartments, and a bunch more. They were able to sell it because their core product had so much momentum, and they built an incredible brand.

But did people actually want these other products they were experimenting with? Not enough, apparently.

Don’t let yourself fall victim to Shiny Object Syndrome — stay focused on your core value prop.

Additionally, most founders default to wanting to give up as little equity as possible. I’ve definitely felt that myself — and Marc Lore even says it’s the one thing he wished he thought differently about early on in his career. But if you firmly believe in yourself and your startup, you’ll always feel like you’re selling yourself short by giving up equity.

I’ve also seen founders feel like they need to “win” negotiations around equity — this is a bad mindset that leads to missing out on opportunities. Investors can also sense this and may treat it as a red flag.

Either way, you may actually prefer to give up more equity if you need to accept more capital than companies at your stage typically do.

A lower valuation can also make sense if the alternative is not getting a deal done, or not getting the right investor on board (yes, the right investor can make a big difference — contrary to the dunking you see on X/Twitter sometimes).

What Happens When You Accept a High Offer?

There are three main risks you take on by accepting high terms:

1. Shiny Object Syndrome causes you to lose flexibility with your business

2. Your entire business becomes vulnerable to shifts in the macro market

3. You may have trouble raising in the future

Let’s say that despite reading this piece you decide to move forward with an aggressive offer from a VC.

You’re thinking about all the things you can do with the money to build a better company.

The reality may end up being different.

I saw this first hand.

After we raised our Series A we went from 4 employees (not including myself and my 2 co-founders) to over 20 within ~6 months.

We did this to grow the business faster and offer more benefits to our customers. The things we added had clear business justifications in our mind, and wouldn’t have been possible without these additional employees.

The problem was that by increasing our fixed costs so quickly, in experimental areas, we got locked into our existing business model. We lost the flexibility that is essential for startups.

We no longer could adapt our model quickly, because our burn would have become untenable if we lost our existing cashflow.

It also made us extremely vulnerable to shifts in the the VC market.

A downturn, like the one we experienced earlier this year and are arguably still in the middle of, would have made it impossible for a startup that had previously raised at high terms to raise again without taking a significant down round.

A startup that’s previously raised at a very high valuation for its stage will have to hit extremely aggressive growth targets in a short amount of time. If it doesn’t, it won’t have an option but to raise a down or flat round.

And this is exactly why we’re seeing so many down rounds right now:

There are upsides to accepting high terms. Everyone takes you a bit more seriously.

Most people assume that your grand vision was simply compelling enough for investors to get excited about, which implies that your company is going to launch some very exciting things that they should pay attention to or want to be part of.

But overall it’s best to be careful. Market volatility and the risk of hampering your future fundraising prospects puts the whole company at risk.

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