The downside of high valuations

As lots of investors are pointing out these days, these are frothy times, especially in the internet sector. Valuations are high. Seed and angel capital has never been more plentiful. My partner JS does a thorough analysis of all this here.

In times of rising valuations, it is important for entrepreneurs to think about their long term funding strategy and choose a valuation that is sustainable not just today but over the whole life cycle of your company. When we hear about high pre-money valuations for companies like Quora it can be tempting to demand higher valuations for your own company.

When it comes to deal structuring, the higher you push the valuation, the more “protections” investors will build in.  Those protections usually are as follows:

Multiple liquidation preferences: It is standard for investors to have a 1x preference. This means that at exit, they have the option to take their investment cost back before any shareholder gets anything or convert and get whatever % of the proceeds they are entitled to. With a multiple preference, investors can take 1.5, 2, 3x or more off the table before you see anything.

Participation: With participating prefs, investors take their liquidation preference (be it single or multiple) off the table AND still get their % of whatever is left. This is known as a double dip.

Dividends: Some pref shares have a cumulative dividend. These dividends usually convert into more shares at a fixed price.  This can be dilutive depending on how long the shares are out there.

Ratchets: It is standard to have what is known as a weighted average anti dilution protection. This means that if you issue shares later at a lower price than the shares you issued today (“down round”) the previous shares get repriced at somewhere between those two issue prices. Some term sheets will provide for a full ratchet, meaning that if you do a down round all shares reset to the new, lower price.

As I was looking through Fenwick & West’s Q3 Silicon Valley VC survey, there are clear signs that these protections are making their way into the deals that are getting done:

– 20% of deals had multiple liquidation preferences. This is up from 17% ( a small jump)

– 53% of deals had participating prefs. This is up heavily from 35% last quarter

The other terms are holding steady so far.

The big thing to remember if you are raising your 1st round, is that whatever rights you give your 1st investors, any new investors will ask for those same rights as a minimum. So, if you push for a very high valuation and as a result the investors need to build in some added protections, then you have set the bar for the protections that will be in all future financings. This can be very expensive for you.

The other issue is that high valuations and protections remove strategic flexibility for you. They leave you little choice but to shoot for an exit that is big enough to deliver returns on those high valuations. And if your deals have lots of protections built in, then you need those high exits if you, as founders, are going to hit the jackpot.

Finally, if you raise at a high price today and that price proves to have been too high based on future deal terms, many future potential investors will just walk away because they don’t want to be the ones that are diluting your current shareholders.

So, frothy times aside, the right deal is about more than the share price today. Think about your long term fundraising strategy. How much capital will you need over the entire life of your business?  Where are deal terms likely to go over that time period and what price should you do today to best set you up for that long term funding roadmap? Complex questions to be sure, but very important for helping you generate and receive the most value in your share ownership.

  • I think this cycle is bound to explode sooner or later. Alignment of interestes is the biggest driver of start-up success. You can raise more money, add peopel, pivot, etc. – but you cannot change the fundamental interest dynamics. Entrepreneurship is about maximizing the probability and size of an exit, not your piece of the pie – expecially when the latter is in conflict with the first two.

    As a founder I went through raising nine rounds of common share financing. It wasn't easy, but I strongly believe that it ultimately made for better ventures. Now that the table is turned, TandemLaunch invests on the basis of common shares. Not to be nice, but as a calculated bet that alignment of interest will create better ventures (and ROI) than financial engineering.